Understanding Bull Ratio Spread

In the previous chapter, we saw how a protective put options strategy can help you limit your losses in the event of unfavourable market movements. In this one, the strategy that we’re about to see is known as the bull ratio spread. It belongs to a family of options trading strategies that traders commonly refer to as spread strategies.

What is the bull ratio spread?

The bull ratio spread is an options trading strategy that traders use when they have a bullish outlook, but the market doesn’t seem to move much. The strategy is designed to generate profits when the price of the asset moves up slightly.

However, depending on the circumstances, it can also generate gains if the asset price stays stable or even falls down a little. The bull ratio spread trading strategy is also referred to by traders as ratio bull spread, ratio call spread, or even call ratio spread.

Here’s a fun fact for you. The reason for the inclusion of the word ‘ratio’ in this strategy has to do with the fact that the number of short and long positions are uneven, thereby creating a ratio. Generally, the ratio used by traders is 2:1, where the number of short positions is twice the number of long positions.

How to set up a bull ratio spread?

While setting up a bull ratio spread might look easy, it requires a little bit of effort. This options strategy involves two call options with different intrinsic values, but with the same expiry. Let’s take a brief look at what you need to do.

• Sell 2 lots of out of the money (OTM) call options
• Purchase 1 lot of at the money (ATM) call options

As you can see from above, the number of call options that you sell are twice that of the number of call options that you purchase.

How does the bull ratio spread work? 

To understand the bull ratio spread trading strategy in a better manner, we’re going to be taking up an example and three scenarios just to see how it works. Before we move on, here’s a quick overview of a few of the assumptions that we’re going to make.

• You have a slightly bullish outlook on Balkrishna Industries Limited.
• The shares of the company are currently trading at Rs. 1,840. 
• However, you don’t expect the stock to move by much and feel that it wouldn’t go past Rs. 1,900 (which would be its resistance).  
• And so, to take advantage of this situation, you decide to set up a bull ratio spread trading strategy. 
• The lot size of the options contract of this stock is set at 400.
• The expiry date of all the options that we’re going to consider would be May, 2021.

Now that we’re done with the assumptions, here’s what you would have to do to set up a bull ratio spread.

• Sell 2 lots of out of the money (OTM) call options, which in this case would be BALKRISIND MAY 1900 CE. Let’s say that the premium for this call option is currently at Rs. 40 per share. By selling 2 lots (which is 800 shares) of OTM call options, you would receive Rs. 32,000 (Rs. 40 x 800).
• Purchase 1 lot of at the money (ATM) call options, which in this case would be BALKRISIND MAY 1840 CE. Assume that the premium for the call option is currently at Rs. 60 per share. So, to purchase 1 lot (which is 400 shares) of ATM call options, you would have to pay Rs. 24,000 (Rs. 60 x 400).

The net credit that you receive out of these two options trades comes up to Rs. 8,000 (Rs. 32,000 - Rs. 24,000).

Scenario 1: The share price falls down below Rs. 1,840 or stays at Rs. 1,840 on expiry

Here’s what would happen if the share price of Balkrishna Industries were to fall below Rs. 1,840 or stay at Rs. 1,840 on expiry.

• The ATM call options that you purchased - BALKRISIND MAY 1840 CE would expire worthless.
• The two lots of OTM call options that you sold - BALKRISIND MAY 1900 CE would also expire worthless.

In this case, your total profit from the bull ratio spread trading strategy would be the net credit amount of Rs. 8,000 that you received due to the trades that you made.

Scenario 2: The share price ends at Rs. 1,900 on expiry

Alternatively, if the share price of Balkrishna Industries were to end at Rs. 1,900 on expiry, here’s what would happen.

• The ATM call options that you purchased - BALKRISIND MAY 1840 CE would make a profit of Rs. 60 per share (Rs. 1,900 - Rs. 1,840), which comes up to a profit of Rs. 24,000 (Rs. 60 x 400).
• The two lots of OTM call options that you sold - BALKRISIND MAY 1900 CE would expire worthless since the strike price is the same as the spot price.

In this case, your total profit from the bull ratio spread would be Rs. 32,000 (Rs. 24,000 + Rs. 8,000).

Scenario 3: The share price goes past Rs. 1,900 on expiry

Now, if the share price was to go beyond the upper strike price, which is Rs. 1,900, the situation would be completely different. Let’s assume for the sake of this scenario that the share price goes up to Rs. 1,920 on expiry. Here’s an overview of what would happen.

• The ATM call options that you purchased - BALKRISIND MAY 1840 CE would turn up a profit of Rs. 80 per share (Rs. 1,920 - Rs. 1,840). This comes up to a total profit of Rs. 32,000 (Rs. 80 x 400).
• The two lots of OTM call options that you sold - BALKRISIND MAY 1900 CE would turn into a loss of Rs. 20 per share (Rs. 1,920 - Rs. 1,900). This comes up to a total loss of Rs. 16,000 (Rs. 20 x 800).

In this scenario, your total profit from the bull ratio spread would be Rs. 24,000 (Rs. 32,000 - Rs. 16,000 + Rs. 8,000).

Wrapping up

In all the three scenarios that we saw above, the bull ratio spread trading strategy turns out a profit. However, this may not be the case in all situations; especially when you get into a ‘net debit’ situation as a result of the two options trades. In cases where there is a ‘net debit’ situation, only scenario 2 may generate profits, whereas scenario 1 and scenario 3 may lead to losses instead.

A quick recap

• The bull ratio spread is an options trading strategy that traders use when they have a bullish outlook, but the market doesn’t seem to move much. 
• The strategy is designed to generate profits when the price of the asset moves up slightly. 
• Depending on the circumstances, it can also generate gains if the asset price stays stable or even falls down a little. 
• The reason for the inclusion of the word ‘ratio’ in this strategy has to do with the fact that the number of short and long positions are uneven, thereby creating a ratio. 
• Generally, the ratio used by traders is 2:1, where the number of short positions is twice the number of long positions.    
• The strategy involves two call options with different intrinsic values, but with the same expiry. 
• Essentially, you sell 2 lots of out of the money (OTM) call options and purchase 1 lot of at the money (ATM) call options.