Most traders are not aware that there are many options strategies out there that can help them increase their returns and minimize the risk. It is necessary to learn how to use the power of stock options to make the most out of it before you deploy your whole capital. Whether your analysis indicates that the price of a particular stock or the index will potentially go higher or lower or will remain range-bound, multiple strategies are available to help you make the most out of your analytical skills.
One such strategy is – call ratio back spread. Using this method of options trading, you can benefit from your positions if the market goes higher. And in case of adversity, you might end up at breakeven or with a minor loss in the worst-case scenario.
Let us dive into knowing this strategy in detail and understand how it works to benefit you from the bullish movement in the prices.
Call Ratio Back Spread
This is a strategy that involves buying the call options as well as selling them to build a favorable setup to gain from the potential up-move. The probability of gaining or losing in this style of trade depends on the ratio that a trader uses to build long and short positions in the call options.
How to build a position using Call Ratio Back Spread?
When your outlook on the price of a particular stock or the value of an index is bullish, you can enter into the following trades to benefit from the up-move:
- Sell one at or in the money call option
- Buy two out of money call options
If the quantity is to be increased, the trader must add up in the same ratio that is 1:2, where one call option is sold against two call options purchased. The ratio is the essence of this strategy. With correct risk management and analyzing pay-off scenarios in advance, some traders might also find using a 1:3 ratio more comfortable where one call option is sold against three call options that are bought.
Risk Management in this Strategy
No options trading strategy can work as a holy grail and all come with a probability of bad failing. Call back ratio spread is no exception to that. If the risk is managed well, traders can gain more and lose less which helps them in the position of net gain.
When you are eyeing a significant up-move in the stock price or the index value, this technique can give you limited loss and unlimited potential gains if your analysis proves right.
Risk management is automatically taken care of in call-back ratio spread as the directional trade is hedged. While you will gain more on the options buying side, you will lose less simultaneously on the call option sold. And in case of a fall in price, you will not gain or lose anything since the net premium will be zero. An example will help you understand this better.
Understand Put Ratio Back Spread with an Example
Let us take a hypothetical situation of Stock P with the following particulars to understand this strategy:
|Current Market Price of Stock P||Rs. 200|
|Lot Size||100 shares|
The below-mentioned call options are available:
|200 Call Option (ATM)||Rs. 12|
|210 Call Option (OTM)||Rs. 6|
To execute trades as per this strategy, you will sell one at the money call option (200 strike price), and collect a premium of Rs. 1,200 (Rs. 12 x 100 shares).
Simultaneously, you will also buy two lots of out-of-money call options (210 strike price), and pay a total premium of Rs. 1,200 (Rs. 6 x 100 shares x 2 lots).
Collection of Rs. 1,200 is set off against payment of Rs. 1,200. So, the net credit or debit of the premium is zero.
Now if the price of Stock P ends at Rs. 200 or anywhere below that level on the day of expiry, you will be at breakeven without any gain or loss. Another breakeven for you would be Rs. 220. Even if the stock price ends at that level, you will have no profit or loss.
To understand the net position at different price levels clearly, we need to analyze it by making a pay-off schedule.
The Pay-off Chart
Continuing with the above example, let us build a pay-off chart at different price levels.
|Stock Price on Expiry||Pay-off from Call Short||Pay-off from Call Long||Net Pay-off|
As you can see in the above pay-off table, there is a possibility of earning unlimited gains and with limited losses as per call back ratio spread.
Call ratio back spread is a good method to initiate positions in derivatives when the trader’s outlook on the stock or index is bullish. It is important to note that volatility is great if the expiry is far, else the volatile days near expiry can cause more loss as the premium price could go all over the place.
Traders can follow either the 1:2 ratio like in the above-mentioned example or the 1:3 ratio where instead of buying two lots of call options, three lots are bought. It is advisable to calculate the risk by drawing a pay-off chart before entering into the trades. As per the positioning of trades, a trader can make less or even no gain if prices move downwards or do not move higher very significantly.