What are Ratio Back Spreads?
A ratio back spread is an options trading strategy in which the trade sells a call option and then uses the premium collected from this order to buy a larger number of call options at a higher strike price than the original call option.
The reason why this strategy is known as a “ratio” is because the number of long calls is always greater than the number of short calls, and the entire trade is expressed as a ratio between the short and long calls. The ratio back spread strategy is used when the trader is highly bullish on an asset.
The ratio of short calls to long calls in ratio back spread options trades, is usually 1:2 or 2:3. In order to setup a ratio back spread option trade, our trader Mr John purchases an option for a stock XY which is currently trading at $43, with a strike price of $50 as follows:
– Short 1 XY 40 Call @ $4.00 per share ($400 for the contract)
– Long 2 XY 45 Call @ $2.00 per share ($400 for the 2 contracts)
The trader will receive a net credit of zero (400 – 400).
The maximum loss that the trader can sustain in this trade is at the strike price of the long call. If the price of XY closes at $45, both long call option contracts will expire worthless while the short call contract will expire in-the-money with an intrinsic value of $5 per share or $500. The trader is then forced to exercise the option by buying it back and this will lead to a $500 loss for the trader.
So if the price of XY gains to $50, both long options expire in the money and the short call expires out of the money and is worthless. As such, the short call has an intrinsic value of -$10 per share and has to be exercised by the trader, leading to a loss of $1000 from the position. The long calls are worth $5 per share each, for a total of $10 per share or $1000. As such, the trader is left with a net value of Zero, which is a breakeven point.
This trade strategy has unlimited upside profit only when the asset has experienced an extremely bullish move. So for our example, anything beyond $50 leads to an unlimited profit potential. For instance, if XY surges to $70 per share on expiration, the short call will expire worthless and the two long calls will have an intrinsic value of $25 per share each, or $50 total. This translates to $5000 profit on the trade, and the net earnings will be $5,000 – $3,000 (value of worthless short call) = $2,000.
In the context of prevalent market conditions in today’s world where stock markets are underperforming, it may be difficult to find an asset that displays such bullishness as we have illustrated in our example. However, there are other assets which can be used to play this strategy. The strategy can also be played in reverse, (put ratio backspread). Do your analyses before engaging in this trade.