A bull call ratio is one of the option spread strategies. Bullish investors generally use this ratio back spread strategy. When the Options Trading investors forecast that the underlying asset price may increase significantly and losses will be less, they execute this Options Strategy.
In this strategy, the options are bought and sold instead of simply buying the call options. You can trade in such a way that maximizes your profit. A trader purchases a large number of call options and sells a relatively low number of options at a different strike price but with the same expiration date.
The trader sells one call option and then buys another call option with the amount collected as a premium. This strategy has an unlimited chance of making a profit as the trader is holding more long calls.
When to apply the Call Ratio Back Spread Strategy?
Call Ratio Back Spread Strategy is suitable when a trader foresees the significant increase in the underlying asset's price and, secondly, when you can accurately judge the market's volatility. In this option strategy, volatility plays a very important role in winning.
Call Ratio Back Spread Strategy is an option spread strategy having 3 legs. It works as below:
Purchasing 2 Out-of-the-money call options
Selling 1 In-the-money or at-the-money call option.
The above 2:1 is the standard ratio used in the Options Strategy, but some traders also consider the 3:2 or 4:2 ratio.
What does a trader receive by applying this options strategy?
A trader may see the following benefits:
Unlimited profit in the case of a price hike
Limited profit or limited loss if the market falls
If the market is stagnant, the loss is predefined.
How does the Call Ratio Back spread options strategy work?
Background: The strategy can only be used when the market is extremely bullish. A moderate bullish market will not work.
Strategy: As discussed, this is a three-legged strategy. A trader must purchase two options against one option sold. In the same way, four options should be purchased against two options sold. While buying and selling, you must keep in mind that the options must have the same expiry, must be from the same underlying asset, and the option traders should follow the standard ratio.
Maximum Loss: If the strike price of the underlying asset of two calls bought is higher at the time of expiration date. A trader faces huge losses. During that time, the highest loss will be the price difference of the options bought and sold, less net credit received while entering the contract, or the expenses incurred upon entering into the contract.
Potential Profit: The theory includes buying two call options contracts, and if the strike price rises, there is huge profit potential. If you are good at making strategies, you can even make a profit when the price falls.
Break-even point at the time of expiration: A trader can experience two breakeven points during the expiration,
A lower breakeven point is when you add a lower strike price and Net credit.
The upper breakeven point is when you add a higher strike price with the Maximum loss.
Let us understand with an example how this strategy works.
Suppose ABC company shares are currently traded at Rs.2000/share.
Now, Mr. Raj (trader) buys two call option contracts having the strike price of Rs.2000 by paying a premium of Rs.200. The lot size of the contract is 100 shares, so he spends Rs. 4,00,000 (2000 price *100 lot size *2 contracts) and 400 as the premium on two contracts (200 for each).
Next step, Mr. Raj sells one call option at a lower strike price of Rs. 1800 per share. The premium for this share is Rs. 600, Technically speaking, Mr. Raj has incurred no cost.
What will he do now? Wait till the options contract expires.
Let us assume the stock price increases from Rs. 2000 to Rs 2500.
So, in this case, Mr. Raj will make a profit of Rs. 500 per share. Thus the total profit comes to Rs. 10,000 ( 500 price rise *200 total shares of two contracts).
Also, Mr. Raj has to execute the contract and sell the shares at Rs. 1800 bearing the loss of Rs 700 per share. He sold one contract of 100 shares; thus, the total amount became Rs. 7000.
So, technically he lost Rs. 7000 by selling the 100 shares, while he also earned Rs. 10,000 in the first transaction.
Calculating his total earnings, he got Rs. 3,200 from this transaction. (10,000 -7,000 +200 premium)
Advantages and disadvantages of the bull call ratio backspread strategy:
This strategy can be very useful when you can predict the upwards movement of the stock price.
It helps protect the trade if the price falls instead of rising.
Some traders believe that options trading is very complex and demands a lot of experience. Believing this, they avoid entering the options market.
We hope you have completely understood the Options Trading with this option spread strategy. The stock market is a field where risk is always there. You cannot eliminate the 100% risk but reduce it to some level by applying proper strategy. Choose the best strategy to protect your capital based on your experience and expertise in the options market.