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The short bull ratio spread is a strategy that serves as an alternative to a simple call option purchase. It possesses nearly all the upside potential of a long call but carries less downside risk, and can be implemented on a nearly cost-free basis.
As with all option ratio writing, both the strikes selected and the ratio of long to short options will impact the profit potential and break-even levels of the trade.
How Is it Implemented?
The short bull ratio spread consists of two legs: the first, a short in-the-money call; the second, multiple at-the-money long calls.
As mentioned above, there’s no hard rule for determining the long-short ratio selected, though ideally the trade is initiated at little to no cost, or even for a slight credit. It’s designed for traders who believe a sharp rise is in the offing, but whose exact timing is in question.
Below is an example of such a trade using Dow 30 component United Technologies (NYSE: UTX):
Let’s imagine that after a steep decline in July, shares of United Technologies bounce higher and your research tells you the move has far more upside to offer. But not being certain of the timing of such a move, you decide to hedge your bets, and instead of buying a call option, prudence leads you to initiate a short bull ratio spread.
With the underlying sitting at exactly $110, you decide to act (red circle). You sell one in-the-money January 106 call for $8 and buy three at-the-money January 110 calls for $2.50 each. The trade produces a $0.50 credit.
Wait! What went wrong!?
In the ensuing 10 weeks, United Technologies shares nosedive, and you wonder what in the world you were thinking. Yet as the stock slips below $98, you still hold out hope. After all, the trade has three months remaining, and you initiated it for a credit. The maximum loss on the venture can only be $350 – the difference between the two strikes – less your initial credit ([$4 – $0.50] x 100). The maximum gain, on the other hand, is unlimited.
And then … things turn around. The stock has an early Santa Claus rally that sends it surging to settle at $119 by the January expiry (blue circle).
Your profit is substantial:
- The short call ends up deep in the money for a $1,300 loss ([$119 – $106] x 100).
- The three long calls are each $9 in-the-money, producing a $2,700 gain.
- Your profit, therefore, is $1,450 (including the $50 credit received at the outset).
How does that compare with a straight purchase of three at-the-money call options?
Well, they would have cost you the same $900 and would have produced the same $2,700 gain. So your net profit would have been $1,800 – superior to the ratio spread’s $1,450, for sure.
But what about the downside?
As mentioned above, the maximum loss for the ratio spread was $350, suffered in the event United Technologies stock closes directly on the long call strike level of $110. On the other hand, the maximum loss for the straight long call trade is, of course, the full amount invested, or $900.
“Less pain and less gain” could be the motto of the short bull ratio spread. But remember, too, it can be launched for little to no cost!
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