Call Ratio Back Spread Options Trading Strategy: Explained with Examples

Background

The Call Ratio Back Spread is a simple-to-deploy options strategy that deserves to be part of your strategy arsenal. Outright bullishness on a stock or index is the driving factor behind this particular strategy, rather than moderate optimism as seen in the Bull Call Spread and Bull Put Spread.

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 typically set up to generate a ‘net credit’, meaning you receive money once you execute the strategy. If the market moves opposite to your prediction (going down rather than up), you will keep the net credit. On the other hand, if your expectation turns out true and the market increases, your potential profit is unlimited. Hopefully this demonstrates why Call Ratio Back Spread can be superior to buying a plain vanilla call option.

So let’s go ahead and figure out how this works.

– Strategy Notes

The Call Ratio Back Spread is a 3-legged option strategy, consisting of buying two out-of-the-money (OTM) call options and selling one in-the-money (ITM) call option. This classic 2:1 combination means two options must be purchased for every one option sold, or four for every two, and so on.

Let us use an example – suppose Nifty Spot is at 7743 and you anticipate Nifty will reach 8100 by expiration. This expresses a positive view of the market. To put in place the Call Ratio Back Spread –

1. Sell one lot of 7600 CE (ITM)
2. Buy two lots of 7800 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. 7600 CE, one lot short, the premium received for this is Rs.201/-
2. 7800 CE, two lots long, the premium paid is Rs.78/- per lot, so Rs.156/- for 2 lots
3. Net Cash flow is = Premium Received – Premium Paid i.e 201 – 156 = 45 (Net Credit)

We will now take a look at how the overall cash flow of the strategies will be affected as expiration levels vary. The call ratio back spread was employed in these transactions.

Take into account that we must assess the strategy payoff at different expiration points, as it is quite varied.

Scenario 1 – Market expires at 7400 (below the lower strike price)

We know the intrinsic value of a call option (upon expiry) is –

Max [Spot – Strike, 0]

The 7600 would have an intrinsic value of

Max [7400 – 7600, 0]

= 0

Since we have sold this option, we get to retain the premium received i.e Rs.201

The 7800 call option has a zero intrinsic value, so the total premium of Rs.78 per lot (or Rs.156 for two lots) has been lost.

Net cash flow would Premium Received – Premium paid

= 201 – 156

= 45

Scenario 2 – Market expires at 7600 (at the lower strike price)

The intrinsic value of both the call options, 7600 and 7800, would be nil, so they will become worthless at expiry.

We keep the premium of Rs.201 from the 7600 CE, but lose Rs.156 on the 7800 CE, giving us a net profit of Rs.45.

Scenario 3 – Market expires at 7645 (at the lower strike price plus net credit)

You might be curious as to why I chose the 7645 level. This was done to demonstrate that the strategy’s break even is located there.

The intrinsic value of 7600 CE would be –

Max [Spot – Strike, 0]

= [7645 – 7600, 0]

= 45

Since, we have sold this option for 201 the net pay off from the option would be

201 – 45

= 156

On the other hand we have bought two 7800 CE by paying a premium of 156. Clearly the 7800 CE would expire worthless hence, we lose the entire premium.

Net payoff would be –

156 – 156

= 0

So at 7645 the strategy neither makes money or loses any money for the trader, hence 7645 is treated as a breakeven point for this trade.

Scenario 4 – Market expires at 7700 (half way between the lower and higher strike price)

The 7600 CE would have an intrinsic value of 100, and the 7800 would have no intrinsic value.

On the 7600 CE we get to retain 101, as we would lose 100 from the premium received of 201 i.e 201 – 100 = 101.

We lose the entire premium of Rs.156 on the 7800 CE, hence the total payoff from the strategy would be

= 101 – 156

= – 55

Scenario 5 – Market expires at 7800 (at the higher strike price)

This is an interesting market expiry level, think about it –

1. At 7800 the 7600 CE would have an intrinsic value of 200, and hence we have to let go of the entire premium received i.e 201
2. At 7800, the 7800 CE would expire worthless hence we lose the entire premium paid for the 7800 CE i.e Rs.78 per lot, since we have 2 of these we lose Rs.156

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

= 201 – 200 – 156

= -155

This also happens to be the maximum loss of this strategy.

Scenario 6 – Market expires at 7955 (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 7600 CE – Intrinsic value of 7600 CE + (2* Intrinsic value of 7800 CE) – Premium Paid for 7800 CE

= 201 – 355 + (2*155) – 156

= 201 – 355 + 310 – 156

= 0

Scenario 7 – Market expires at 8100 (higher than the higher strike price, your expected target)

The 7600 CE will have an intrinsic value of 500, and the 7800 CE will have an intrinsic value of 300.

The net payoff would be –

Premium Received for 7600 CE – Intrinsic value of 7600 CE + (2* Intrinsic value of 7800 CE) – Premium Paid for 7800 CE

= 201 – 500 + (2*300) – 156

= 201 – 500 + 600 -156

= 145

Here are the other levels of option expiry, along with their potential payoffs. It’s worth noting that gains are larger when the market goes up, but there is still potential for a limited profit even if it decreases.