In addition to the four basicOption strategies (Long Call, Short Call, Long Put, Short Put), as well as straddles, strangles and vertical spreads, the so-called ratio spreads are somewhat less well known. Among experienced option traders, however, the ratio call spread and the ratio put spread are quite popular strategies. The Ratio Call Spread consists of one or more purchased call option(s), as well as sold call options of different quantity.
Definition Ratio Call Spread
A ratio call spread is an option strategy that consists of a purchased call option (long call) and several call options sold (short call) with a higher strike price and the same remaining term. The ratio of short calls to long calls is usually 2:1 or 3:1; in principle, however, the strategy can also be traded with any other ratio (e.g. 4:1, 3:2, 5:3, etc.).
The ratio call spread is usually used when speculating that the underlying will move sideways or slightly bullish. Depending on the choice of strike prices and the ratio, costs or premium income are incurred when opening a trade.
The price range where the maximum profit occurs is typically a few points above the current market price. However, if the underlying rises very sharply, the upside loss potential is unlimited.
P&L diagram of a ratio call spread
In the profit and loss diagram you can see that the ratio call spread (here: ratio 2:1) profits from a moderate bullish movement of the underlying. A loss occurs in the case of strongly rising prices.
What should I pay attention to when trading a ratio call spread?
The Choice of base prices can be adjusted to the own market expectation. Often a strike price is chosen for the long call that is At The Money or slightly Out Of The Money. Depending on the choice of strike prices, the profit zone shifts and a credit (premium income) or debit (cost) is created when the trade is opened.
In case of a strong bullish movement of the market, there is an unlimited potential for losses, which is why strict risk and money management is required. The ratio call spread is a rather complex strategy and therefore suitable for experienced options traders.
Maximum and realized loss
If the underlying rises far above the strike price of the short calls, a loss is incurred. Depending on the ratio (2:1, 3:1, etc.), you can think of the ratio call spread as a Bull Call Spread with one or more additional short calls.
With a 2:1 ratio call spread, you first calculate the profit of the bull call spread (width of the spread). Then you calculate the loss of the additional short call (price underlying - strike price short call) and can thus determine the profit/loss. Depending on whether you paid or collected a premium for the opening of the trade, it will be added or subtracted.
The maximum loss cannot be calculated, as it can theoretically be unlimited.
Maximum profit
The maximum profit arises if the underlying is exactly at the same level on the expiration date. Price level of the short calls is quoted. Thus, the sold calls expire worthless and the purchased call generates a profit. The amount of the profit corresponds to the width of the spread plus the option premium collected or minus the option premium paid.
Maximum profit = strike price short call - strike price long call + net credit
Or:
Maximum profit = strike price short call - strike price long call - net debit
Break Even Point
If the underlying rises above the price level of the short calls, a loss is incurred with the sold options, which is initially compensated by the profit of the long call. The further the price rises, the lower the profit and the higher the loss after the break-even point has been reached.
To calculate the break-even point, the possible Maximum profit added to the price level of the short calls.
Break Even Point = Strike PriceShort Call + Maximum Profit