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Call Ratio Backspread

Call Ratio Backspread

Table of Contents

Basics Concepts – Call Ratio Back spread

Basics Concepts – Call Ratio Back spread

Description – Call Ratio Backspread

  • The Call Ratio Back spread is an exciting strategy that enables us to make accelerated profits provided that the stock moves sharply upwards.
  • Increasing volatility is very helpful because we’re net long in calls.
  • The worst thing that can happen is that the stock doesn’t move at all
  • The Call Ratio Backspread involves buying and selling different numbers of the same expiration calls.
  • We buy and sell calls in a ratio of 2:1 or 3:2, so we are always a net buyer.
  • Sell one or two lower strike calls.
  • Buy two or three higher strike calls with the same expiration date.
  • The ratio of bought to sold calls must be 2:1 or 3:2.
  • You will be trying to execute this trade at no cost or for a slight net credit.
Description – Call Ratio Backspread

Steps to Trading a Call Ratio Backspread

Steps In

  • Try to ensure that the trend is upward and identify a clear area of support.

Steps Out

  • Manage your position according to the rules defined in your Trading Plan.
  • If the stock falls below your stop loss, then unravel the entire position.
  • In any event, look to unravel the trade at least one month before expiration, either to capture your profit or to contain your losses.

Context - Call Ratio Backspread

Outlook

  • With call ratio backspreads, your outlook is aggressively bullish— you are looking for increasing volatility with the stock price moving explosively upwards.

Rationale

  • To execute a bullish trade for little to no cost while reducing your maximum risk.
  • You are looking for the stock to rise significantly.

Net Position

  • You want to do this as a net credit or zero cost transaction in order to minimize your maximum risk and cost.
  • Your maximum risk on the trade itself is limited to the difference in strikes less your net credit, all multiplied
    by the number of contracts you are selling.
  • Your reward on the trade is unlimited.

Effect of Time Decay

  • Time decay is generally harmful to your position—you want as much time to be right as possible because you are looking for such a large move.

Time Period to Trade

  • You will be safer to choose a longer time to expiration

Breakeven Down = [Lower strike + net credit]

Breakeven Up = [Higher strike price + (difference in strike prices * number of short calls)/(number of long calls -number of short calls) – [net credit received] or + [net debit paid]]

Exiting the Trade - Call Ratio Backspread

Exiting the Position

  • With this strategy, you can simply unravel the spread by buying back the Call options you sold and selling the call options you bought in the first place.
  • Advanced traders may leg up and down or only partially unravel the spread as the underlying asset fluctuates up and down.

Mitigating a Loss

  • Unravel the trade as described previously.
  • Advanced traders may choose to only partially unravel the spread leg-by-leg and create alternative risk profiles.

Advantages and Disadvantages

Advantages

  • Reduced cost of making the trade.
  • Capped risk (especially if the underlying stock moves with high volatility).
  • Uncapped and high leverage reward if the stock price rises.

Disadvantages

  • More risk if the stock does not move
  • Comparatively complicated trade for the intermediate trader.

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