Call Ratio Spread – The Advanced Neutral Trading Strategy

Call Ratio Spread is an advanced Option Trading Strategy used on Neutral Market Condition. Find all details about this Option Trading Strategy here.

About Call Ratio Spread

The Call Ratio Spread is one of the advanced options trading strategies used largely in neutral market conditions.

The ratio spread is a neutral trading option wherein a trader holds an unequal number of long and short positions. It is in a definite ratio.

Now, the call ratio spreads specifically in the form of ratio spread that we create using call options. This neutral trading option profits the traders regardless.

It is the same even if the stock price goes up, down, or remains static for a considerable period.

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How does Call Ratio Spread work?

It is a complex options trading strategy that involves two simultaneous transactions and is never suitable for beginners.

Traders using this strategy buy call options and simultaneously sell fewer put options at a lower price to gain profits. The call ratio spread is a neutral strategy that is bullish on volatility.

It is the only one having a credit spread with unlimited profit potential. There is a variety of neutral options trading strategy.

We use each of these, like the call ratio spread, depending on the market conditions and situations.

Situations that demands the use of Call Ratio Spread

Even though the call ratio spread is a neutral trading option, it is best suitable in situations when the trader expects a slight rise in the stock price. It happens if it remains within the neutral market condition.

As a neutral trading method, it can generate profits in all three probable conditions. The traders use it to reduce upfront costs.

They ensure no losses even if the assets exhibit a downwards or sideways movement. We should use the call ratio spread only if the trader can predict a small rise.

Now, with the chances of small drops or stable stock prices, simultaneously, we don’t consider it suitable if there is the slightest chance for the stock price to increase.

It may then increase significantly, and it might bring losses.

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Establishing a Call Ratio Spread Strategy

The call ratio spread strategy is not for newbie traders due to its complex structure. It comprises an unequal number of component options.

This particular trading method involves two simultaneous transactions or legs (steps or components in a multistep trade).

They are buying and selling options, all on the same underlying asset having a common expiration date.

Traders usually need to use two types of call options, ‘In the Money (ITM) and Out of the Money (OTM), to implement the call ratio spread strategy.

The ITM options refer to options with intrinsic value, and the OTM identifies options that only have extrinsic value.

The first transaction that is usually in the call ratio spread is purchasing a specific number of “In the Money” call options.

The second leg involves writing Out of the Money call options. They are higher in value than the ITM bought in the first leg. The cost of the Money call options is comparatively higher.

This is the reason why the “Out of the Money call” options should be larger in number to yield better profits.

It has to be so when the stock value rises. The major aim of conducting these transactions is to create a credit spread and gather a significant net credit in the trade.

Ratio and Strike Price in Call Ratio Spread

Even though the number of call options bought and sold in this strategy is never equal, there should essentially be a specific ratio between the two. The ratio of options sold to options purchased is largely the choice of the trader.

However, 2:1 and 3:1 is considered standard or easy to handle in the initial stages. On choosing the 2:1 ratio, a trader has to write 2 Out of the Money calls for each In the Money calls bought.

The trader also has to choose the strike wisely, and it is often recommended to purchase Out of the Money calls and writing calls at higher strikes.

A simple example of creating net credit using a call ratio spread described here can explain the call ratio spread with more clarity,

• Consider the strike price of calls to be Rs 2100 for a company that trades its stock at Rs 2100 per share, and the trader has to buy and write calls at a price higher than this.
• The trader purchases an option for Rs 28000 in the first leg and writes two contracts for Rs 42000 in the strategy’s second leg.
• These transactions would establish a call ratio spread with a 2:1 ratio, creating a net credit of Rs 14000.
• If the stock price goes above Rs 2100 by the expiration, the trader can have a good profit or remain stable without loss. On the other hand, if the stock prices decrease largely, the trader might significantly lose. Therefore, the strike price has to be selected appropriately.

This is a comparatively straight example that does not include any of the complexities involved in the strategy.

Find out more relevant Neutral Option Trading Strategy below

Profits and losses of constructing Call Ratio Strategy

The call ratio spread involves the risk of loss, which arises mainly when the stock price goes dramatically higher than the expectations of the trader since the strike price set by the trader based on the predictions decides the loss and profit of this strategy.

Despite this possible risk of loss, the strategy has the potential to provide unlimited profits.

In the example mentioned above, if the company’s stock price rises slightly to around Rs 2240 before expiry, then the trader can generate profits from the contract purchased in the first leg.

Similarly, if the stock remains neutral, the trader can profit from the net credit created by selling and purchasing contracts. We can summarize the profits and losses involved in call ratio spread in the following manner,

Unlimited/maximum profit- We can obtain a maximum profit out of the “call ratio spread” in two different ways,

1. If the stock price remains equal to the strike price of options in the second leg.
2. [(strike price in the second leg – strike price in the first leg) x number of options purchased in the first leg] + net credit.

Profit

We can generate a significant profit using this strategy in the following manner –

1. The net credit was created from the transactions.
2. If the stock price is less than or equal to strike price in the first leg.
3. Stock price > first-leg strike price < second leg strike price.
4. [(stock price – strike price of options in the first leg) x number of options purchased in the first leg] + net credit.

Loss

The strategy might result in a loss in the following manner –

1. If the stock price shows a sharp rise.
2. Traders can calculate the loss as (the price of options in the second leg – the price of options in the first leg) – net credit.

Benefits and drawbacks of Call Ratio Options Strategy

The call ratio spread is a neutral trading strategy that has its benefits and drawbacks for the traders. The most prominent advantage of the trading method is the potential to generate maximum profits.

It is a bullish on volatile strategy that profits to a certain extent in rising, dropping or neutral trends of the underlying assets.

One of the added benefits of call ratio spread is that traders can generate credit spread. Moreover, this approach does require any form of upfront payment from the trader. The complexity of the strategy itself is one of the largest issues that make it unfit for beginners.

Complexity exists at every level, including transactions and choosing the right ratio and strike price. The strategy is not completely free of risks that might bring losses to the trader.

The strategy may fail and bring losses if the trader fails in predicting the amount of possible rise in the stock.

Call Ratio Spread – Conclusion

The call ratio spread is a popular ratio options trading strategy that expert investors use. There is a wide variety of neutral option trading strategies, out of which “call ratio spread” is a complex method. It requires critical decision-making abilities in traders.

The strategy can provide profit returns in three major stock situations, exhibiting a rise, fall, or neutral trend.

It depends on the investor’s expectations of a small rise, strike price, and the ratio of purchasing and selling options.

The call ratio spread strategy is bullish on volatile strategy and maximizes profit with a small rising tendency in asset value.

The investors opting for this particular approach have to understand the risks of losses in the call ratio spread.

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