Short Bull Ratio Spread is an advanced option trading strategy used only by traders. This strategy is used in bullish market condition.
Know everything about this strategy here.
About Short Bull Ratio Spread
The Short Bull Ratio Spread is an options trading strategy used to profit from the bullish market conditions, like only buying calls.
However, by creating this short bull spread, the trader can reduce his upfront cost. There is a potential for unlimited profits in this strategy.
The strategy is simple in a way, as it has only two transactions involved. However, beginners are still advised to refrain from making use of the Short Bull Ratio Spread.
The only reason behind this is that to benefit from this strategy; an exact ratio needs to be maintained. This precision can only come with experience and expertise in the market.
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When to use a Short Bull Ratio Spread?
The Short Bull Ratio Spread is established when the trader is confident of a sharp increase in the underlying security price.
By using this options trading strategy, the trader can maximize his earning potential while reducing the upfront cost.
There is also a minimization of losses in case the market behaves unexpectedly.
How a Short Bull Ratio Spread works?
To implement the Short Bull Ratio Spread, two simultaneous transactions are done. These transactions include:
- Buying an ATM or slightly OTM call
- Writing off ITM call options
Due to the higher costs of ITM call options, fewer ITM calls are written off, compared to the number of call options bought. This ratio between the number of calls purchased and sold is the main game-changer in this strategy.
The ratio used largely depends on the preference of the trader. However, the most commonly used ratio to create the Short Bull Ratio Spread is 3:1. That is, for every three ATM calls bought, 1 ITM call option is written off.
The wider the difference is between the ITM and ATM calls’ strike prices, the lesser number of calls need to be written off.
The implementation of a Short Bull Ratio Spread can be understood better using the following example:
Suppose the price of Company X stock is trading at INR 500, and you expect the price to go up in the coming future.
The ATM calls for a strike price INR 500 is trading at INR 20. The ITM calls for a strike price INR 450, is trading at INR 60.
In order to implement the Short Bull Ratio Spread, you buy three lots of 75 options each, at a total price of INR 4500.
You now write off one call contract containing 75 options. This gives you a credit of INR 4500. Now, you have created a short bull spread with zero net upfront cost.
Case 1: The price of the company’s stock rises to INR 600
Now the calls you have bought have increased to the price of INR 30. So, now they would be worth INR 6750.
Also, the written-off calls have a risen liability of INR 80, leading to the total liability of INR 6000. This gives you a profit of INR 750 in the overall transaction.
Case 2: The price of the company’s stock remains at INR 500
At this expiry price, the calls you bought become worthless. On the other hand, the calls you had written off have a liability of around INR 50 for INR 3750.
This is the maximum possible Loss you can incur using the Short Bull Ratio Spread.
Case 3: If the price of the company’s stock falls to INR 450
The calls you had bought become worthless at this price, and so will the calls you had written off. This makes it the break-even point in your trade.
The above cases can be summarized as:
The higher the rise in price, the greater would be the profits. If the price falls below the lower strike, then you would exit at almost break-even levels.
Know about other Bullish Option Trading Strategies
|Long Call||Bull Condor Spread||Butterfly Bull Spread|
|Bull Ratio Spread||Bull Call Ladder Spread||Short Put|
|Bull Call Spread||Bull Put Spread|
Profit and loss Potential of Short Bull Ratio Spread Strategy
The profit potential of the Short Bull Ratio Spread is unlimited. Till the price of the underlying security keeps on rising, the profits keep on increasing.
The losses are limited. The maximum Loss occurs when the security’s expiring price is equal to the strike price of the calls bought.
The profit and loss calculations can be done using the following formulae:
Profit= (Current price of the security- Strike price of calls bought)*Number of options in the contract-(Current price of security- Strike price of calls written off)*Number of options in the contract
In the given example, (Case-1)
= INR 3750
If you created a net debit spread instead of zero cost, then that would be deducted from total profits.
Maximum Loss = (Current price of the security- Strike price of call options written off)*Number of options in the contract
In the given example, (Case-3)
Maximum Loss= (600-450)*75
= INR 11250
If instead of zero cost, any debit spread was created, then that would be added to your net Loss.
How to minimize risk while using Short Bull Ratio Spread?
The most significant advantage of the Short Bull Ratio Spread is the minimum Loss and risk potential. If you wish to minimize the risks further, then you can avoid taking any overnight positions.
This could save you from losses of sudden gap openings. Also, never forget to put a stop loss. Based on your risk appetite, you can adjust your stop loss.
Advantages of the strategy:
- Potential to earn unlimited profits. In this case, the only condition is that there should be an upside price movement in the chosen security.
- It is possible to create the spread even with zero or minimal upfront costs.
- The possible losses which the trader can incur are minimal. Even if the underlying security price falls drastically instead of rising, the losses would not be endless.
Disadvantages of the strategy:
- The amount of profits is comparatively lesser than only buying options. But, due to the lesser underlying costs, the trade-off seems realistic.
- In order to get the maximum benefits, it is essential to strike the right ratio. This can only come with experience.
Short Bull Ratio Spread – Conclusion
When you are confident about an increase in price, it is worth trying to create the Short Bull Ratio Spread. This strategy exponentially increases your profit margins while reducing the upfront cost.
This strategy’s effectiveness depends on striking the right ratio and prices for buying and writing off calls.
So, if you have learned the tactics of movement of prices, then you can definitely try this options trading strategy.
The strategy has the following characteristics –
- Maximum profit is unlimited
- Maximum Loss when the price at expiry= strike price of calls bought
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