Ratio call spread ( Front Spread with Calls)

The Ratio Call Spread, often referred to as a Front Spread with Calls, is an advanced options strategy used when an investor has a moderate bullish outlook on a stock but also wants to hedge against potential downside risk. This strategy involves buying calls at a lower strike price and selling a greater number of calls at a higher strike price within the same expiration period.

The Setup

Let's assume you're analyzing DEF Corp, which is currently trading at $200 per share. You might set up a Ratio Call Spread by buying one call option with a strike price of $200 for $10 and selling two call options with a strike price of $220 for $4 each. Both options expire in three months.

Who Should Consider It

This strategy is suitable for investors who expect a moderate increase in the underlying asset's price but also want to protect against downside risk or even profit from a potential decline. It's also attractive for those looking to benefit from the decay of time value in the options they have sold.

Strategy Explained

In a Ratio Call Spread, the number of higher strike call options sold exceeds the number of lower strike call options bought. The premium received from selling the higher strike calls partially or fully offsets the cost of the lower strike calls. This strategy can often be initiated for a net credit or at no cost.

Breakeven Process

The breakeven points can be more complex due to the multiple call options involved. Typically, the upper breakeven point is found by adding the net premium received or paid to the higher strike price, adjusted for the ratio of the options. The lower breakeven would be near the lower strike price but may be offset by any net premium received.

Sweet Spot

The sweet spot for this strategy occurs when the stock price is at or slightly above the higher strike price at expiration. This scenario maximizes the profit potential from the spread before the additional sold calls cause losses.

Max Profit Potential

The maximum profit is generally limited and occurs when the stock price is equal to the strike price of the calls sold. The profit is the difference between the strike prices minus the net cost of the spread, adjusted for the number of options traded.

Max Loss

The maximum loss is theoretically unlimited since selling more calls than are bought exposes the investor to excess call assignment. If the stock price skyrockets, the losses on the extra short calls could be substantial.

Risk

The primary risk involves the stock price rising significantly beyond the higher strike price of the sold calls. Since more calls are sold than bought, the investor is exposed to unlimited upside risk.

Time Decay

Time decay works in favor of this strategy, particularly on the sold call options. As expiration approaches, the value of the short call options can decay faster than the long call, provided the stock price doesn't rise dramatically.

Implied Volatility

An increase in implied volatility has a mixed impact because it can increase the value of both the long and short positions. Generally, this strategy benefits from a decrease in implied volatility, especially after the position is established, as it will decrease the value of the higher strike short calls more significantly.

Conclusion

A Ratio Call Spread is a nuanced strategy that requires careful management due to the risks from the additional short calls. It's best suited for experienced traders who can monitor and adjust their positions as market conditions change. This strategy can be highly profitable in the right market conditions but carries significant risks if the market moves unfavorably.