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Friday September 03, 2010 |
Advanced Strategies for Options -
Vertical Spreads - 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
|
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47
|
($400)
|
$1,000
|
$600
|
|
50
|
($100)
|
$1,000
|
$900
|
|
53
|
$200
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$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
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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.
bear
put spread 
reverse ratio spread
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Vertical
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