Options Trading Made Easy: Call Diagonal Ratio Backspread

Properly initiated, the call diagonal ratio backspread can make money in strongly trending markets – either up or down – as it’s structured to profit from volatility. The gains will be maximized should the underlying surge higher, but should the opposite occur, the trader is still guaranteed his initial credit.
The trade could also produce losses if the underlying security drifts sideways through the final expiration.
How is it set?
Like a regular call ratio backspread, there are two legs:

1. The short sale of an at-the-money call; and
2. The purchase of two out-of-the-money calls.

The only difference is the expiries. The regular ratio backspread has a single expiry, while the call diagonal ratio backspread consists of two separate expiries, with the short call expiring before the longs.
Remember, too, that the use of a 2-to-1 ratio in the above description is not monolithic. Traders will employ whatever quantity is right for their particular option, strike, expiry and overall trading reality.
Let’s move now to a specific trade example, the better to understand all the possible risks and rewards of the trade.
Here’s a chart of beer-can maker Ball Corp. (NYSE: BLL) for a six-month span:

In January, your research tells you that a new acquisition and a change in management will bring a strong net positive to Ball’s bottom line, and the shares will likely fly once all the pieces are finally in place.
You want to buy calls on the stock, but if the deal is delayed or called off you fret about losing your premium.
After further deliberation, you decide to employ a call diagonal ratio backspread, a trade that will essentially pay for itself, will still offer you some upside if everything moves as expected, and could also bring you a small sum, too, if you’re wrong.

Stuffing Your Pockets

With the stock at $65 you decide to act (red circle). You sell two at-the-money February 65 calls for $3 each and buy four out-of-the-money March 69 calls for $1.40 apiece. Total credit on the trade is $0.40.
Then it begins. News of the deal nearing completion hits the wires and the shares take off, trading up to $77 by the first expiry (blue circle).
Your short calls are $12 in the money, creating a $2,400 loss. But the four long calls are trading for $11 each, for a $4,400 take – if you close the trade now.
What to do?  Should the shares continue higher you could see more profits, but you’ll lose the fat time premium ($3) that’s currently on offer. Should they retrace, you’ll lose both time and intrinsic value, and you’ll still be clinging to a $2,400 loss from the short calls.
It’s not an easy choice, but your tendency toward risk aversion leads you close out both legs on options expiration day and take home your $2,040 profit (including initial credit).

Worst-Case Scenarios

Determining strict break-even levels for the trade is not realistic with diagonal (calendar) trades, as too many variables come into play. Steepest losses will occur when, as in the above example, the underlying trends strongly higher and the trader holds his long position, only to see the stock back off significantly into the long call strike (black circle).
Trader’s tip: It’s almost always advisable to close both legs if a profit is attained by the first expiry.

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