Understand the Call Ratio Spread Strategy in Options Trading

A Call Ratio Spread is a popular options trading strategy investors use to capitalize on specific market scenarios. This strategy involves a combination of call options with varying strike prices and aims to achieve particular risk-reward outcomes. Understanding and implementing a Call Ratio Spread requires a grasp of options trading basics and a strategic approach to managing potential market movements.

What is Call Ratio Spread?

A Call Ratio Spread is one of the most applied options trading strategies to benefit from anticipated bearish or bullish market movements. It involves the simultaneous purchase and sale of call options on the same underlying asset with different strike prices and contract quantities. This strategy’s primary goal is to generate profit by leveraging an investor’s speculation on the price movement of the underlying security.

To execute this strategy, an investor typically buys a specific number of at-the-money or slightly in-the-money call options and simultaneously sells a greater quantity of out-of-the-money call options. The ratio between the options bought and sold creates a spread that influences the strategy’s risk-reward profile.

This strategy has several potential outcomes based on the market’s movement:

1. Bullish Expectation: When investors anticipate a moderate rise in the underlying asset’s price, they execute a Call Ratio Spread with more call options sold than purchased. This allows them to benefit from limited upward movement while mitigating the cost of establishing the position.

2. Neutral or Bearish Expectation: In cases where an investor foresees a stagnant or bearish trend, they may execute this strategy with more options purchased than sold. This setup allows for potential profits if the underlying asset’s price remains unchanged or decreases slightly, maximizing gains if the market moves in the predicted direction.

   However, it’s crucial to note that it involves varying degrees of risk. The potential loss is limited to the initial investment in the options. In contrast, the profit potential can be capped or unlimited, depending on the strike prices chosen and the spread ratio. Investors should thoroughly comprehend the risks associated with this strategy before implementation and consider consulting with a financial advisor or expert before trading options.

Example

Let’s consider a Call Ratio Spread example involving this strategy on a company’s stock, ABC Ltd., trading at Rs 500 per share.

Assume an investor is moderately bullish on ABC Ltd.’s stock but wants to limit potential losses. They decide to execute this strategy.

1. Purchase: The investor buys 2 call options of ABC Ltd. with a strike price of Rs 510 expiring in two months at Rs 20 per option (1 option contract represents 100 shares). The total cost of buying these options is Rs 4,000 (2 options * Rs 20 * 100 shares).

2. Sale: Simultaneously, the investor sells 3 call options of ABC Ltd. with a strike price of Rs 530, expiring in two months at Rs 10 per option. The total credit received from selling these options is Rs 3,000 (3 options * Rs 10 * 100 shares).

The net cost of initiating this position is Rs 1,000 (Rs 4,000 – Rs 3,000).

Possible Outcomes:

1. Bullish Scenario: If ABC Ltd.’s stock price climbs to Rs 540 at expiration, both the purchased and sold call options are in the money. The investor exercises the purchased options at Rs 510, gaining Rs 30 per share (Rs 540 – Rs 510). Since one call option represents 100 shares, the total profit is Rs 6,000 (Rs 30 * 100 shares * 2 options). However, the investor must sell 300 shares (3 options * 100 shares) at Rs 530 due to the sold options, resulting in a loss of Rs 9,000 (Rs 10 * 100 shares * 3 options). Netting these gains and losses, the overall loss amounts to Rs 3,000 (Rs 6,000 – Rs 9,000).

2. Bearish or Neutral Scenario: If ABC Ltd.’s stock price remains below Rs 510, both the purchased and sold options expire worthless. In this situation, the investor incurs a maximum loss of Rs 1,000—the initial net cost of establishing the position.

Call Ratio Spread Strategy

Here’s a detailed look at how the Call Ratio Spread works:

1. Strategy Initiation: The investor simultaneously buys a specific number of at-the-money or slightly in-the-money call options and sells more out-of-the-money call options on the same underlying asset. The ratio between the options bought and sold establishes the risk-reward parameters of the option trading strategies.

2. Bullish Outlook: When anticipating a moderate rise in the underlying asset’s price, an investor might execute a Call Ratio Spread with more call options sold than purchased. This approach allows them to benefit from limited upward movement in the asset’s price while reducing the cost of establishing the position.

   Recommended Read: What are Option Greeks?

3. Neutral or Bearish Outlook: In cases where an investor foresees a stagnant or bearish trend, they may opt for a Call Ratio Spread with more options purchased than sold. This setup enables potential profits if the underlying asset’s price remains unchanged or decreases slightly while leveraging the premium collected from the sold options.

Risk and Reward

The maximum potential loss for the investor is typically limited to the initial net debit paid to establish the position. Conversely, the potential profit can vary and might be limited if the underlying asset’s price moves significantly in the anticipated direction.

The strategy offers a structured approach to options trading, allowing investors to tailor their positions to specific market expectations while managing potential risks. However, understanding the associated risks is crucial before implementing such options trading strategies. Therefore, investors should conduct thorough research or seek guidance from financial experts or advisors to comprehend the complexities and potential outcomes of employing Call Ratio Spreads.

Formula

The Call Ratio Spread combines different quantities of long (buy) and short (sell) call options on the same underlying asset. Its formula determines the number of long and short call options and their respective strike prices.

Here is the formula:

1. Long Calls: Determine the number of long call options (N1) to be purchased. These are typically at-the-money or slightly in-the-money options.

2. Short Calls: Calculate the number of short call options (N2) to be sold. These are usually out-of-the-money options.

   The ratio of long calls to short calls (N1:N2) defines the spread ratio and significantly influences the strategy’s risk-reward profile. It could be, for instance, 1:2, 2:3, or any other proportion based on the investor’s market outlook and risk tolerance.

   Recommended Read: Risk Capacity and Risk Tolerance

   Additionally, the strike prices of the long and short call options should be determined based on the expected movement of the underlying asset. The long calls usually have lower strike prices, while the short calls have higher strike prices.

Conclusion

The Call Ratio Spread strategy presents a versatile tool for investors in options trading, enabling tailored positions based on market expectations. While offering potential profits in diverse scenarios, it limits losses to the initial investment.

Understanding the risks and consulting with experts is vital before employing this strategy. Its structured approach allows for strategic risk management, but investors should undertake thorough research and exercise caution to maximize its benefits in navigating the complexities of options trading.