Advanced Strategies for Options - Reverse Ratio Spread (Backspread)

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Advanced Strategies for Options - Reverse Ratio Spread (Backspread)

The reverse ratio spread is one of the most common applications for the ratio spread – and for good reason, the strategy usually yields large profits if the underlying security behaves as expected. The reverse ratio spread is executed when the investor sells a call at one strike price and buys several calls at the higher strike price. As the name suggests this is the exact reverse of the traditional ratio spread.

The reverse ratio spread is actually a long call added to a bear spread. The bear spread portion of the transaction requires collateral in the amount of the difference between the two strike prices.

In the reverse ratio spread the investor wants the stock to move dramatically and if the spread is executed for a credit the direction of the move is unimportant. In a nutshell the investor achieves large potential profits if the stock moves up dramatically but there is also limited profit potential if the stock declines.

How can this be? Because the investor owns a greater number of the out-of-the money calls he achieved unlimited upside profit potential but the fact that the spread is initiated for a credit means that the maximum downside potential is equal to the initial credit received. In layman's terms the investor is buying an out-of-the money call and hedging himself by selling another call. If the stock rises as anticipated he makes a bundle but should the stock collapse he also profits because all the calls expires worthless and he retains his net credit.

This strategy has limited risk and unlimited profit potential. Now let’s take a closer look at this strategy that seems too good to be true.

Jonathan believes Atmel (ATML) has big upside potential. He thought about buying the stock outright but he wants to leverage his capital. After some consideration Jonathan decides to establish a reverse ratio spread. With ATML currently trading at 45 Jonathan sells one contract of the ATML January 40 call at $4. He buys 2 contracts of the ATML January 45 calls at $1. The entire transaction results in a net credit of $2 per contract or $200.

Now let’s take a closer look at this transaction.

Atmel Price at Expiration	Profit for January 40 calls	Profit for 2 January 45 calls	Total Profit
35	$400	($200)	$200
40	$400	($200)	$200
45	($100)	($200)	($300)
50	($600)	$800	$200
55	($1,100)	$1,800	$700
60	($1,600)	$2,800	$1,200
65	($2,100)	$3,800	$1,700
70	($2,600)	$4,800	$2,200

As we can see from the table above Jonathan has the potential to make substantial profits from this transaction. His maximum loss occurs when ATML shares move to $45. As with most spreads the maximum loss is attained at expiration if the common stock closes at the strike price of the purchased call. If ATML shares close below $45 Jonathan still collects a cool $200 but should the stock rally substantially, as anticipated, Jonathan’s potential profits are unlimited.

Summary

1. Reverse ratio or backspreads can been a very powerful option strategy if the position can be established for a credit. Downside risk is limited to the net credit and upside profit potential is unlimited.

2. The maximum loss occurs if the underlying common stock closes at the strike price of the purchased call.

3. Because there are no naked calls in this strategy the initial investment is relatively small.

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