Everything to Know about the Call Ratio Back Spread Option Strategy
Investing in options contracts requires advanced trading knowledge. Furthermore, the premium that one has to pay may negate the profits or in some cases may lead to losses. Although there are no obligations to exercise options if the current market price is below the strike price, a trader can still lose money on brokerage and other charges.
So is there a way to ensure profits when the market trends go up or down? You can do so by using a Call Ratio back Spread (CRBS) options strategy. In this blog, we will be discussing how this strategy works with an example and its underlying benefits and risks.
What Is the Call Ratio Back Spread Strategy?
The CRBS is suitable for traders speculating on an adverse market trend, without knowing the direction of market movement. It involves buying a certain number of call options at a higher strike price and selling a fewer number of call options at a lower strike price.
Usually, this strategy is executed in a 2:1 combo, with 2 options bought for 1 option sold. This way traders can generate income that can help them offset any potential loss if the underlying asset moves against them.
To execute this strategy, a trader typically sells one in-the-money (ITM) call option at a lower strike price and purchases two or more out-of-the-money (OTM) call options at a higher strike price. The difference between premiums received and given is used to reduce the cost of the higher strike call.
How Does Call Ratio Spread Option Strategy Work?
To better understand how CRBS options trading works, let us consider the following example.
Suppose a trader buys one call option with a strike price of ₹500 and sells two call options with a strike price of ₹450. The lot size is say 100 shares.
|Call sold||₹450||₹40 (received)|
|Call Purchased||₹500||-₹15 (paid)|
|Call Purchased||₹500||-₹15 (Paid)|
Overall premium = (₹40 – (₹15 + ₹15)) x (lot size) = ₹1,000
The formula to calculate the net payout on trading options is:
Net profits = (Strike price – options price at expiry) ± (premium cost)
Here, the strike price for call options sold is ₹450, whereas the strike price for call options purchased price is ₹500.
Therefore, say if the asset is trading at ₹410 during expiration, then the premium received for call options sold will be ₹40. This is because the contract will expire worthless, although the buyer has to pay the premium.
Similarly, if the stock trades at ₹470, then the outcome will be as follows:
Profits = (Strike price – options price at expiry) – (premium cost) = (₹450 – ₹470) + ₹40 = ₹20
Simultaneously, the premium paid for purchasing 2 call options at ₹500 when the asset trades at ₹470 will stand worthless. However, the buyer will have to pay ₹15 as a premium for each stock.
Here is a look at the net receivables at various market prices
|Market Price at Expiry||Premium For Call Options Sold||(Premium For Call Options Purchased)x2||Net Payout|
As the table suggests, traders can profit without limits if the market is bullish and has an adverse upward trend. However, an adverse downward trend will not incur losses, as the net premium will negate overall losses. This is because a CRBS strategy takes advantage of obligation-exempt trading. The buyer is allowed to avoid exercising a contract if the market price is trading below the strike price at expiry.
The call ratio back spread trading strategy follows a ratio of short and long calls are 1:2, 2:3, or 1:3. Lastly, CRBS options trading can help traders hedge their portfolio against a significant market movement. However, traders can also incur losses on small market shifts.
Advantages of the Call Ratio Back Spread Strategy
Here are some advantages of CRBS strategy for trading
- One of the main advantages of a call ratio back spread is that it can be used to generate income from an upward market movement. Furthermore, it ensures that the trader does not incur a loss even if the prices drop.
- Another advantage of the call ratio back spread strategy is that it limits the risk of losses. In other cases, an extreme swing in asset prices may lead to significant losses. However, CRBS allows traders to offset potential losses via net premium payoff.
- Lastly, the CRBS is a flexible strategy that can be used to generate income or limit risks in different market conditions. Although the profits might not be high in a bearish market, a bullish market can yield unlimited returns.
Disadvantages of the Call Ratio Back Spread Strategy
Some of the disadvantages of the CRBS strategy are as follows
- The strategy is designed to limit losses, but the trader may incur losses if the liable premium is more than the receivable premium. Furthermore, as illustrated in the table below, differences in incoming and outgoing premiums may also lead to losses.
- Finally, the call ratio back spread strategy can be complex and requires a high level of trading experience. Traders should fully understand the risks and potential rewards of this strategy before executing it.
The CRBS strategy is a popular options trading strategy used by experienced traders to profit from volatile markets. However, as stated in the above sections, it has some underlying risks. Therefore, one must have a sound knowledge of market trends and advanced skills to conduct a proper cost-benefit analysis beforehand.
Overall, with calculated moves and predictions, one can earn significant profits in a bullish market using the CRBS strategy.
Frequently Asked Questions
- What is the difference between trading call ratio back spread and put ratio back spread?
Call ratio back spread options are a bullish trading strategy when traders anticipate upward market trends. On the other hand, put ratio back spread options are a bearish trading strategy when traders speculate downward market trends.
- Why should I employ the CRBS options strategy?
The goal of a call ratio back spread is to earn potential profits from adverse downward and upward market trends. However, only the extreme scenario attracts high profits.
- What is the difference between back-ratio and front-ratio spread?
Options with more short positions than long positions are said to be a front-ratio spread. In contrast, back spreads consist of more long positions than short positions.
- How is call ratio back spread option trading managed?
Traders can either buy one In-The-Money or At-The-Money call option or at the same time sell 2 Out-of-The-Money call options.