4.1 -Framework

The Call Ratio Spread is an interesting option strategy. This strategy is interesting due to its simplicity and potential payoff. This strategy should be a part of your strategy arsenal. This strategy can be used when one is bullish on a stock or index, unlike the bull call spread and bull put spread when one is moderately bullish.

This is the experience you'll have when you implement Call Ratio Back Spread.

1. Unlimitable profit in the event of a rising market
2. Limited profit if market goes down
3. If the market stays within a certain range, a predefined loss

Simply put, you can make money as long the market is moving in any direction.

The Call Ratio Back Spread is usually deployed for a net credit. This means that money flows into your account immediately after you execute Call Ratio Back Spread. If the market falls, your net credit is what you will make. If the market does indeed rise, you can make an unlimited profit. This should explain why the spread on call ratios is better than buying plain vanilla options.

Let's now see how it works.

4.2 -A note for strategies

The Call Ratio Spread, a 3-leg option strategy, involves two OTMs purchasedCall optionSelling one ITMCall option This is the classic 2:2 combination. Call ratio back spreads must be in the 2:1 ratio. This means that for every option sold, 2 options need to be purchased. For every 2 options, 4 options must be purchased.

Consider this: Nifty Spot is currently at 7743. You expect Nifty will reach 8100 before expiry. This is clearly a bullish outlook for the market. The Call Ratio Back Spread can be implemented here

1. SellOneLot of 7600 CE (ITM).
2. BuyTwoLots of 7800 CE (OTM).

You should ensure that -

1. Both the Call options and the call options have the same expiry
2. The same underlying
3. This ratio is maintained

This is how the trade setup looks.

1. 7600 CE, one lot less, the premium for this is Rs.201/.
2. 7800 CE, two lots, the premium is Rs.78/– per lot, or Rs.156/– for 2 lots
3. Net cashflow=
   recieved premium(201) - paid premium(156)
   i.e 45 (Net credit)

These trades are used to execute the call ratio back spread. Let's see what happens to the cash flow at different levels of expiry.

We need to assess the strategy payoff at different levels of expiry, as the strategy payoff can be quite flexible.

Scenario 1: Market closes at 7400 (below lower strike price).

The intrinsic value of a call options (upon expiry), is known to be -

Max [Spot-Strike, 0]

7600 would hold an intrinsic value i.e

Max [7400-7600, 0]

= 0
Net cashflow=
received premium +paid premium

We retain the premium we received for this option (i.e. Rs.201) because we have sold it.

The total premium paid(78/ lot) or for two lots rs.156 will be lost as the 7800 call option would have zero intrinsic value.

Net cash flow would Premium received - Premium paid

= 201 - 56

=45

Scenario 2: Market expires at 7600 (at a lower strike price).

Both the call options 7600 and 7800 have zero intrinsic value, so they expire without any use.

We retain the premium paid, i.e. Rs.201 towards 7600 CE. However, we lose Rs.156 for 7800 CE. This results in a net payout ofRs. 45

Scenario 3: Market expires at 765 (at the lower strike prices plus net credit).

You may be asking why I chose the 7645 level. This is because this is where the strategy breakeven point is.

The intrinsic value for 7600 CE would be:

Max [Spot-Strike, 0]

= [7645-77600, 0]

= 45

We have now sold this option for $201, the net profit from the option being

201 - 45

= 156

We have paid a premium of just 156 to buy two 7800 CE. The 7800 CE would be worthless so we lose the whole premium.

The net payoff would be -

156 -156

=0

At 7645, the strategy does not make or lose any money. Therefore, 7645 can be considered a breakeven point.

Scenario 4: Market expires at 7700 (halfway between the lower strike price and the higher).

The 7600 CE would have a 100-year intrinsic value, while the 7800 CE would not.

We retain 101 on the 7600 CE, as 100 would be lost from the premium of 201.

The entire premium of Rs.156 is lost on the 7800 CE. Therefore, the strategy's total payoff would be

= 101 - 56

=- 55

Scenario 5: Market closes at 7800 (at a higher strike price).

This is a fascinating market expiry level. Think about it.

1. The 7600 CE at 7800 would have an intrinsic worth of 200. Therefore, we must let go of all premiums received.
2. The 7800 CE would be worthless at 7800 CE. We lose the premium of Rs.78 per lot. Since we have 2 CE, we lose Rs.156

This is a double whammy point in the strategy!

The strategy's net payoff is -

Premium received for 7600 CE. - Intrinsic value 7600 CE. - Premium paid for 7800 CE.

= 201-200 - 156

=-155

This is also the strategy's maximum loss.

Scenario 6: Market expires at 795 (higher strike, i.e 7800 + Max Loss)

This strike was chosen to show that the strategy breakseven at 7955

You may be wondering if we have dealt with a breakeven sooner.

This strategy has two breakeven points. One on the lower side (7645), and one on the higher side (7955).

The strategy's net payoff is -7955

Premium received for 7600 CE – Intrinsic Value of 7600 CE + (2* Insic Value of 7800 CE+) - Premium Paid For 7800 CE

= 201 - 355 + (2*155), - 156

= 201 - 355 +310 - 156

=0

Scenario 7: Market expires at 8100 (higher strike price than your target).

The 7600 CE will have a intrinsic value 500 and the 7800 CE 300.

The net payoff would then be -

Premium received for 7600 CE – Intrinsic Value of 7600 CE + (2* Insic Value of 7800 CE+) - Premium Paid For 7800 CE

= 201-500 + (2*300), - 156

= 201 - 500 +600 -156

=145

There are many other exit points and the ultimate payoff for the strategy. You should note that the market rises, so do the profits. However, if the market falls, you still make money, though it is limited.
 
 

4.3 - let's Generalize the strategy

We can draw few conclusions based on the scenarios discussed above.

• Spread = Higher Strike, Lower Strike
• Net Credit = Premium received for lower strike - 2*Premium for higher strike
• Spread = Max Loss - Net Credit
• Max Loss occurs at = Higher Strike
• When the market falls, you get paid = Net Credit
• Lower Breakeven = Lower Strike + Credit
• Upper Breakeven = Higher Strike and Max Loss

This graph highlights these key points.

You will notice that the payoff is flat regardless of the market's decline, with the maximum loss at 7800 and the increase in payoff beyond 7955.

4.4 -Greeks to be welcomed back

These graphs are probably familiar to you. These graphs display the profitability of the strategy based on the expiry date. This helps traders choose the best strikes.

__S.40__
__S.42__

 

The following is important before you understand the graphs.

1. The Nifty spot is believed to be at 8000
2. The start of a series can be defined as any time within the first 15 days.
3. End of the series means that the series has ended within the last 15 days.
4. The Spread of Call Ratio Back Spread has been optimized. It is created with 300 points difference

This suggests that the market will rise by approximately 6.25%, i.e. from 8000 to 82500. The graphs below suggest that -Considering the market move and the expiry time,

1. Graph 1 (top-left) and Graph 2. (top-right)- If you are near the beginning of the expiry sequence and expect the move to occur over the next five days (and fifteen days in the case of Graph 2) then a Call Ratio Spread of 7800 CE (ITM), and 8100 CE(OTM) is the best option.Most profitableyou could sell 7800 CE, and buy 2 8100 CE.you will buy 2 8100CE and sell 7800 CE.
2. Graph 3 (bottom left), and Graph 4(bottom right).- You are near the beginning of the expiry series, and you anticipate the move in25 days(or expiry day in the case of Graph 3), then a Spread Call Ratio with 7800 CE(ITM) or 8100 CE(OTM) would be the most profitable. This spread would allow you to sell 7800 CE and purchase 2 8100 CE.

You may be curious as to why the strike selection is consistent regardless of expiry date. This is true. The call ratio back spread works best when the OTM option is purchased and sold slightly.There is plenty of time for expiry. All other combinations are losing money, especially those with far OTM options. This is especially true if you expect to reach the target closer to expiry.

Another set of charts is available. During the 2nd half in the series , the move(6.25)occurs and this is the only difference.

 

1. Graph 1 (top-left) & Graph 2. (top-right)If you anticipate the move within the 2ndYou expect the move within the first half of the series.A day (or within 5 Days, graph 2)The best strikes to opt for are ITM and slightly ITM, i.e 7600 or lower strike short and 7900 long. This is not an ITM + OTM spread. It is instead an ITM/ITM spread. All other combinations are not effective.
2. Graph 3 (bottom left) & Graph4 (bottom right).If you anticipate the move within the 2ndYou expect the move within the first half of the series.10 days (or on expiry, graph 4)The best strikes to opt for are those with deep ITM or slightly ITM, i.e 7600 (lower striking short) and 7900 long (7900). Similar to graph 1, graph 2, this is also true.

The key to this strategy's profitability is not only the direction, but also the strike selection. To ensure that your strategy is successful, you must be diligent in mapping the time until expiry to the correct strike.

How does volatility affect this strategy? You can see how volatility is a major factor in this strategy by looking at the image below.

Three colored lines represent the change in "net premium", aka strategy payoff, versus volatility. These lines allow us to see the impact of volatility increase on strategy payoff while keeping time to expiry in perspective.

1. Blue LineThis line indicates that volatility increases when there is enough time for expiry (30 days), which is good for the Call ratio back spread. The strategy payoff goes up from -67 and +43 when volatility rises from 15% to 30%. This means that when there's plenty of time for expiry, you need to be able to see the volatility and also have an accurate view of the stock/index direction. Even though I am bullish on the stock, I wouldn't hesitate to deploy this strategy early in the series if volatility is higher than usual (say, more than twice the normal volatility reading).
2. Green lineThis line indicates that volatility increases when there is approximately 15 days before expiry. However, it is not as beneficial as in the previous case. The strategy payoff goes up from -77 and -47, respectively, when volatility increases by 15% and 30%.
3. Red line -This is a fascinating, but counterintuitive outcome. An increase in volatility when there are few days before expiry can have a negative effect on the strategy. If volatility is high when there are fewer days before expiry, it increases the likelihood that the option to expire OTM. The premium will decrease. If you are bullish about a stock/index with a few days before expiry and expect volatility to rise during that period, then you should thread cautiously.

Keypoints

1. When your outlook on the stock/index and call ratio backspread are bullish, it is best to execute the Call Ratio Backspread
2. This strategy will require you to sell 1 ITM CE to buy 2 OTM CE. The ratio must be the same, i.e. for every 1 option sold, 2 options must be purchased
3. The strategy is typically executed to obtain 'net credit'
4. The strategy will make a small profit if stock prices fall, but a large profit if they rise. Loss is pre-defined
5. There are two types of break even points: the lower and upper breakeven points
6. Spread = Higher Strike, Lower Strike
7. Net Credit = Premium received for lower strike - 2*Premium for higher strike
8. Spread = Max Loss - Net Credit
9. Max Loss occurs at = Higher Strike
10. When the market falls, you get paid = Net Credit
11. Lower Breakeven = Lower Strike + Credit
12. Upper Breakeven = Higher Strike and Max Loss
13. No matter when the strike expires, you can choose a slightly ITM + OTM combination.
14. This strategy is best when volatility increases with more time before expiry. However, if volatility drops, it is not a good strategy.