Ratio call spread ( Front Spread with Calls)

The Ratio call spread Setup

Let’s say you are looking at DEF Corp which is trading at $200. You might set up a Ratio Call Spread by buying one call for $200 at $10 and selling two calls for $220 at $4 each. Both options expire in 3 months.

Who Should Do It

This is for those who expect a moderate move up in the stock but want to protect against downside or even profit from a decline. It’s also for those who want to benefit from time decay in the options they sold.

How It Works

In a Ratio Call Spread, you sell more calls at a higher strike than you buy at a lower strike. The premium from the higher strike calls offsets or covers the cost of the lower strike calls. This can be done for a credit or no cost.

Breakeven

The breakeven points are more complicated due to the multiple options involved. Typically the upper breakeven is the net premium received or paid added to the higher strike price, adjusted for the ratio of the options. The lower breakeven is near the lower strike but may be offset by the net premium received.

Sweet Spot

The sweet spot is when the stock is at or slightly above the higher strike at expiration. This maximizes the profit from the spread before the extra sold calls start to lose money.

Max Profit

The max profit is limited and occurs when the stock is at the strike of the calls you sold. The profit is the difference between the strikes minus the cost of the spread, adjusted for the number of options.

Max Loss

The max loss is unlimited since you are selling more calls than you bought and are exposed to call assignment. If the stock skyrockets, the losses on the extra short calls could be big.

Risk

The main risk is when the stock price goes up significantly above the higher strike price of the sold calls since more calls are sold than bought, the investor is exposed to the infinite upside risk.

Time Decay

The time decay is in the favor of the strategy, especially on the sold call options. The deeper we are into the expiration week, the market price of the short call options can decay more than the long call, provided that the stock price doesn’t jump too high.

Implied Volatility

Implied volatility spikes have shown that they can give mixed results. The reason is that both long and short positions are increased. Normally, this strategy enjoys the benefit of a reduced in the implied volatility, primarily after the position is established as it will decrease the value of the higher strike short calls more significantly.

Conclusion

The Ratio Call Spread is a somewhat complicated strategy, which is the main reason why it requires effective control due to the hazards from the additional short calls. Thus the preferable traders will be the ones who are advanced and have the capability to screen out and make changes in their situation as the market develops. Although this strategy can become immensely advantageous in case the market conditions are favorable, but in fact, it also presents high risks if the market moves unfavorably.