Bull Call Ratio
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The Call Ratio Back Spread is an interesting options strategy. I call this interesting keeping in mind the simplicity of implementation and the kind of pay off it offers the trader. This should certainly have a spot in your strategy arsenal. The strategy is deployed when one is out rightly bullish on a stock (or index), unlike the bull call spread or bull put spread where one is moderately bullish.
At a broad level this is what you will experience when you implement the Call Ratio Back Spread-
1. Unlimited profit if the market goes up
2. Limited profit if market goes down
3. A predefined loss if the market stay within a range
In simpler words you can get to make money as long as the market moves in either direction.
The Call Ratio Back Spread is a 3 leg option strategy as it involves buying two OTM call option and selling one ITM Call option. This is the classic 2:1 combo. In fact the call ratio back spread has to be executed in the 2:1 ratio meaning 2 options bought for every one option sold, or 4 options bought for every 2 option sold, so on and so forth.
Let take an example – assume Nifty Spot is at 11575.95 and you expect Nifty to hit 12000 by the end of expiry. This is clearly a bullish outlook on the market.
To implement the Call Ratio Back Spread –
1. Sell one lot of 11500 CE (ITM)
2. Buy two lots of 11700 CE (OTM)
Make sure –
1. The Call options belong to the same expiry
2. Belongs to the same underlying
3. The ratio is maintained
The trade set up looks like this –
1. 11500 CE, one lot short, the premium received for this is Rs.151/-
2. 11700 CE, two lots long, the premium paid is Rs.46/- per lot, so Rs.92/- for 2 lots
3. Net Cash flow is = Premium Received – Premium Paid i.e 151 – 92 = 49 (Net Credit)
With these trades, the call ratio back spread is executed. Let us check what would happen to the overall cash flow of the strategies at different levels of expiry.
Do note we need to evaluate the strategy payoff at various levels of expiry as the strategy payoff is quite versatile.
Case 1 – Market expires at 11300 (below the lower strike price)
The 11500 would have an intrinsic value of 0
Since we have sold this option, we get to retain the premium received i.e. Rs.151
The intrinsic value of 11700 call option would also be zero; hence we lose the total premium paid i.e Rs.46 per lot or Rs.92 for two lots.
Net cash flow would Premium Received – Premium paid
= 151 – 92
Case 2 – Market expires at 11500 (at the lower strike price)
The intrinsic value of both the call options i.e 11500 and 11700 would be zero, hence both of them expire worthless.
We get to retain the premium received i.e Rs.151 towards the 11500 CE however we lose Rs.92 on the 11700 CE resulting in a net payoff of Rs.49.
Case 3 – Market expires at 11549 (at the lower strike price plus net credit)
The strategy break even is at this level.
The intrinsic value of 11549 CE would be 49
Since, we have sold this option for 151 the net pay off from the option would be
On the other hand we have bought two 11700 CE by paying a premium of 92. Clearly the 11700 CE would expire worthless hence, we lose the entire premium.
Net payoff would be –
92 – 92
So at 11545 the strategy neither makes money or loses any money for the trader, hence 7645 is treated as a break-even point for this trade.
Case 4 – Market expires at 11600 (half way between the lower and higher strike price)
The 11500 CE would have an intrinsic value of 100, and the 11700 would have no intrinsic value.
On the 11500 CE we get to retain 51, as we would lose 100 from the premium received of 151 i.e 151 – 100 = 51.
We lose the entire premium of Rs.92 on the 11700 CE, hence the total payoff from the strategy would be
= 51 – 92
= – 41
Case 5 – Market expires at 11700 (at the higher strike price)
This is an interesting market expiry level, think about it –
1. At 11700 the 11500 CE would have an intrinsic value of 200, and hence we have to let go of the entire premium received i.e 151 and also lose another Rs. 49
2. At 11700, the 11700 CE would expire worthless hence we lose the entire premium paid for the 11700 CE i.e Rs.46 per lot, since we have 2 of these we lose Rs.92
So this is like a ‘double whammy’ point for the strategy!
The net pay off for the strategy is –
Premium Received for 7600 CE – Intrinsic value of 7600 CE – Premium Paid for 7800 CE
= 151 – 200 – 92
This also happens to be the maximum loss of this strategy.
Case 6 – Market expires at 11841 (higher strike i.e 7800 + Max loss)
I’ve deliberately selected this strike to showcase the fact that at 7955 the strategy breakeven!
But we dealt with a breakeven earlier, you may ask?
Well, this strategy has two breakeven points – one on the lower side (7645) and another one on the upper side i.e 7955.
At 7955 the net payoff from the strategy is –
Premium Received for 11500 CE – Intrinsic value of 11500 CE + (2* Intrinsic value of 11700 CE) – Premium Paid for 11700 CE
= 151 – 341 + (2*141) – 92
= 151 – 341 + 281 – 92