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Friday September 03, 2010 |
Advanced Strategies for Options -
Vertical Spreads - 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
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Profit
for 2 January 45 calls
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Total
Profit
|
|
35
|
$400
|
($200)
|
$200
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40
|
$400
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($200)
|
$200
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|
45
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($100)
|
($200)
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($300)
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50
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($600)
|
$800
|
$200
|
|
55
|
($1,100)
|
$1,800
|
$700
|
|
60
|
($1,600)
|
$2,800
|
$1,200
|
|
65
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($2,100)
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$3,800
|
$1,700
|
|
70
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($2,600)
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$4,800
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$2,200
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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.
ratio spread
butterfly spread
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Home > Education > Using Options > Advanced Strategies >
Vertical
Spreads > Reverse Ratio Spread
