Advanced Strategies for Options - Ratio Call Spread

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Advanced Strategies for Options - Ratio Call Spread

A ratio call spread is a neutral strategy in which an investor buys a number of calls at a lower strike price and sells more calls at a higher strike price. The ratio call spread involves uncovered calls. Because some calls are uncovered the greatest risk occurs when the underlying common stock rises substantially; in fact theoretically upside risk is unlimited. In a ratio spread the profit or loss at expiration is constant below the lower strike price because both options are worthless at that level. The maximum profit for a ratio spread occurs if the stock is exactly at the strike price of the short (higher) option.

In terms of margin requirements a ratio spread is essentially a bull spread and a naked call write. There is no margin requirement for the bull spread other than the net debit. For most brokerage firms the margin requirement for the naked call is 20% of the stock price plus the call premium less the amount the naked call is out-of-the money.

You might wonder why any investor would want to use a strategy with unlimited upside risk and limited profit potential. There are essentially three competing philosophies regarding ratio spreads, the ratio spread as ratio write, ratio spreads for credits and the delta ratio spread.

Ratio Spread as Ratio Write

A very common hedge strategy is the ratio write. In this strategy the investor buys common stock and sells a ratio of call options against that common stock. Portions of these calls are covered by the underlying common stock and a portion is “naked”. The theory behind this strategy is to protect the long common stock position against downside risk. If the common stock remains relatively unchanged the investor keeps the entire call premium and realizes a profit on the transaction.

Some option strategist's view the ratio spread as a cheap version of the ratio writes. If an investor can purchase calls for little to no time value they simulate a long stock position. By establishing a ratio hedge on the long call position the ratio write can be simulated at a fraction of the cost. Consider this example.

Justin believes Dell Computer (DELL) stock will be mired in a trading range for the next month. He considers buying 100 shares at 50 dollars and simultaneously selling 2 January 50 calls for $5. In this case his out of pocket cost would be $4,000 (100 shares of Dell at $50 less the proceeds from the sale of 2 contracts of the Dell January 50 calls at $5 per contract). That transaction is a little pricey for Justin’s liking so he decides to do the same thing with options. He buy 1 contract of the January 40 call at $11 and simultaneously sell 2 contracts of the January 50 call for $5 creating a debit of just $100. Presto, Justin just saved himself $3,900.

That sounds too good to be true. Let’s take a closer look at this transaction.

Dell Computer Share Price at Expiration	Profit for January 40 calls	Profit for 2 January 50 calls	Total Profit
35	($1,100)	$1,000	($100)
38	($1,100)	$1,000	($100)
41	($1,000)	$1,000	$0
44	($700)	$1,000	$300
47	($400)	$1,000	$600
50	($100)	$1,000	$900
53	$200	$400	$600
56	$500	($200)	$300
59	$800	($800)	$0
62	$1,100	($1,400)	($300)
65	$1,400	($2,000)	($600)

As we can see this spread establishes a profit range when the stock is trading between $41 and $59. Justin’s maximum profit is achieved when Dell shares remain at the $50 level and he has unlimited upside risk because he is responsible for one naked January call. If Dell shares rise above $62 things get ugly quickly.

Summary

1. The ratio spread as a ratio write can be an attractive alternative for investors who want to establish a neutral position for an underlying security to collect premium. If the stock remains relatively stable downside risk is limited and profit potential is excellent.

2. The maximum profit for a ratio spread established for a debit is determined by multiplying the number of long calls by the difference between the strike prices less the net debit.

3. The upside break-even point is determined by dividing the maximum points of profit by the number of naked calls plus the higher strike price.

4. The downside break-even point is determined by dividing the maximum points of profit by the number of naked calls less the higher strike price.

5. The maximum downside risk for call ratio spreads established for a debit is limited to the net debit.

6. The upside risk for the call ratio spread is unlimited.

7. For most brokerage firms the margin requirement for the naked call is 20% of the stock price plus the call premium less the amount the naked call is out-of-the money.

Ratio Spread for Credits

A second philosophy of ratio spreads involves establishing them only for credits. When an investor follows this philosophy he will generally want the underlying stock price to be below the strike price of the written calls when the spread is established. This type of ratio spread has no downside risk because if the stock collapses the spreader will make a profit equal to the initial credit received.

Since the underlying stock price is generally below the maximum profit point when the spread is established this spread is mildly bullish. The investor wants the stock to move up slightly in order to obtain the maximum profit. Upside risk is still unlimited.

Now that we have a handle on some of the particulars of this philosophy let’s take a closer look at a case study.

Michelle believes Coca-Cola (KO) shares are likely to remain in a narrow trading range as the company completes a large restructuring. With KO shares currently trading at 44 Michelle decides to establish a ratio spread for a credit. She buys 1 contract of the KO January 40 call at $5 and sells 2 contracts of the KO January 45 calls for $3. These transactions create a net credit of $100.

Now let’s examine this transaction more closely.

Coca Cola Share Price at Expiration	Profit for January 40 calls	Profit for 2 January 45 calls	Total Profit
39	($500)	$600	$100
42	($300)	$600	$300
45	$0	$600	$600
48	$300	$0	$300
51	$600	($600)	$0
54	$900	($1,200)	($300)
57	$1,200	($1,800)	($600)
60	$1,500	($2,400)	($900)
63	$1,800	($3,000)	($1,200)
66	$2,100	($3,600)	($1,500)

As we can see Michelle is “sitting pretty” as long as KO shares continue to trade at $51 or less but the transaction gets “pretty ugly” once the stock advances above that level Michelle obtains her maximum profit of $600 if KO shares trade at $45 on the expiration date and her maximum loss is unlimited.

Summary

1. Ratio spreads established for a credit can be attractive for investors that believe the stock will remain in a relatively tight trading range. Because this position is established for a credit there is no downside risk but upside risk is unlimited.

2. The maximum profit is the number of long calls multiplied by the difference in the two strike prices plus the net credit. MP = # long calls X difference in strikes + net credit

3. The break-even point is calculated by dividing the maximum profit by the number of naked calls plus the higher strike price. BE = max profit/# of naked calls + higher strike price.

4. The maximum downside risk is zero because the position is established for a net credit.

5. For most brokerage firms the margin requirement for the naked call is 20% of the stock price plus the call premium less the amount the naked call is out-of-the money.

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