The ratio call spread may be an appropriate strategy for the investor who expects a slight rise in the market, but sees the potential for a sell-off. The strategy consists of the purchase of a call option and the sale of multiple call options with a higher strike price.
|When to use the ratio call spread|
|Market outlook||mildly bullish|
|The ratio call spread|
|Construction||long call X, short calls Y|
|Point of entry||market around X|
|Breakevens at expiry||higher strike price less maximum profit of spread;
higher strike price plus maximum profit of spread
|Maximum profit at expiry||difference between strike prices less cost of spread|
|Maximum loss at expiry||unlimited on upside; cost of spread on downside|
|Time decay||market around lower strike: hurts
market around higher strike: helps
|Margins to be paid?||yes, on naked calls|
|Synthetic equivalent||long stock; long put X, short calls Y|
Profits and losses
If the share price is at the higher strike price of the spread at expiry, the maximum profit point will be reached. The potential for profit is partly dependent on how many calls have been sold against each call taken. Generally the ratios are opened on a 1:2 basis and rarely higher than 1:3 due to the increased risk this would introduce should the shares rise strongly.
If the shares fall, the trader can lose no more than the cost of the spread. This protection against a fall in the price of the shares is greater than in the case of a bull call spread due to the higher number of written positions in place. However, if a strong upward movement occurs unexpectedly the trader faces potentially unlimited losses. The higher the number of unprotected calls that have been written, the larger the loss that could be incurred.
Ideally the spread is opened for a profit, which involves no risk if the shares fall.
- Market strengthens: the ratio call spread provides good protection for the investor in the event of a market downturn. The price of this protection is the possibility of a loss should the market move further upwards than expected.
- Exercise: because the strategy involves uncovered written positions, the risk of exercise must be considered. The trader must meet the collateral requirements of the uncovered calls.
The main threat to the ratio call spread comes from a greater than expected strengthening in the market. If this occurs, the trader may consider closing out the spread, or alternatively closing out the sold options to reduce the risk of exercise.
If the share price falls dramatically, the trader may buy back the long call before it loses too much time value. The danger in closing out the long position is that a market reversal leaves the trader totally exposed on the short legs.
Points to remember
- This strategy benefits from a small upward movement in the market. It should not be used if a strong upward movement is expected.
- Be wary of constructing the strategy on a ratio higher than 1:2.
- Be prepared to act quickly if the share price jumps unexpectedly.
After a rise in the market over the last six months, you believe there is still some possibility for the shares to rise further. However, given recent highs reached overseas, you fear the possibility of a downward correction. You decide to place a ratio call spread in RST Limited shares.
Buy 1 Sep $5.00 Call @ $0.38 and
Sell 2 Sep $5.50 Calls @ $0.13
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