Understanding Call Ratio Back Spread Strategy and the Importance of Time to Expiry and Volatility

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Strategy Generalisation

Going by the above discussed scenarios we can make few generalizations –

  • Spread = Higher Strike – Lower Strike
  • Net Credit = Premium Received for lower strike – 2*Premium of higher strike
  • Max Loss = Spread – Net Credit
  • Max Loss occurs at = Higher Strike
  • The payoff when market goes down = Net Credit
  • Lower Breakeven = Lower Strike + Net Credit
  • Upper Breakeven = Higher Strike + Max Loss

 

– Welcome back the Greeks

You should already be acquainted with these graphs. The below figures demonstrate the profitability of the strategy when taking time to expiry into account, enabling traders to make the suitable selection of strikes.

 

Before understanding the graphs above, note the following –

  1. Nifty spot is assumed to be at 8000
  2. Start of the series is defined as anytime during the first 15 days of the series
  3. End of the series is defined as anytime during the last 15 days of the series
  4. The Call Ratio Back Spread is optimized and the spread is created with 300 points difference

It is believed the market will rise 6.25%, to 8500, from its starting point of 8000. Accordingly, the graphs above appear to show –

  1. Graph 1 (top left) and Graph 2 (top right) – You are at the start of the expiry series and you expect the move over the next 5 days (and 15 days in case of Graph 2), then a Call Ratio Spread with 7800 CE (ITM) and 8100 CE (OTM) is the most profitable wherein you would sell 7800 CE and buy 2 8100 CE. Do note – even though you would be right on the direction of movement, selecting other far OTM strikes call options tend to lose money
  2. Graph 3 (bottom left) and Graph 4 (bottom right) – You are at the start of the expiry series and you expect the move in 25 days (and expiry day in case of Graph 3), then a Call Ratio Spread with 7800 CE (ITM) and 8100 CE (OTM) is the most profitable wherein you would sell 7800 CE and buy 2 8100 CE.

You may be asking why the choice of strikes remains unchanged regardless of the time to expiry. The answer is this – the call ratio back spread performs optimally when you sell an option slightly in-the-money and buy one slightly out-of-the-money when there’s enough of time left. All other options are not as advantageous, particularly those involving far out-of-the money options and especially if you envision obtaining your goal nearer to expiration.

It’s important to emphasize that strike selection is paramount to the success of this strategy. Careful consideration of time to expiry when selecting strikes will ensure the desired outcome is obtained.

Volatility is a major factor that needs to be taken into account when considering this strategy.

 

The three coloured lines represent the change in “net premium” or the strategy payoff when volatility changes. They help us comprehend how increasing volatility affects the strategy, taking into account the remaining time until expiration.

  1. Blue Line – The Blue Line suggests that an increase in volatility when we have plenty of time until expiry (30 days) can be beneficial for the Call ratio back spread. As shown, the strategy’s payoff increases from -67 to +43 when there is a jump in volatility from 15% to 30%. This implies that, in addition to predicting the direction of the stock/index correctly, you should also have an opinion on volatility when there is ample time to expiry. Therefore, even if I’m bullish on this security, I might think twice before deploying this strategy at the start of the series if we see a relatively high level of volatility (higher than double our usual reading).
  2. Green line – It appears that, when there are around 15 days until expiry, an increase in volatility can be advantageous – albeit to a lesser extent than previously. We can observe that the strategy payoff increases from -77 to -47 as volatility rises from 15% to 30%.

Red line – The result of this is certainly counterintuitive. When there are very few days left until expiration, an increase in volatility actually has a negative effect on the strategy. To put it another way, if there’s not much time remaining and volatility begins to rise, there’s a greater chance that the option will end up Out of The Money, causing the price to fall. As such, those who remain bullish on a particular stock or index with little time left before expiration should exercise caution.

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