Reverse Ratio Call Backspread

In a previous article, “Bull Call and Bear Put Spreads” investors learned how to construct a simple 1:1 vertical spread. This week we will discuss how a ratio spread can be implemented and the risks and benefits of this strategy. A ratio spread is similar to a vertical spread in that it involves the simultaneous purchase and sale of options of the same underlying and expiry. Unlike a 1:1 vertical spread the number of options contracts bought and sold is at a minimum 1:2 ratio, but the ratio can be greater depending on your forecast. There are no naked options as the long options always outnumber the short options.

Canadian investors with a forecast for greatly increasing volatility can use Ratio Backspreads to get volatility exposure without having to pay a debit for the spread. The Call Backspread involves the selling of an In-The-Money call while buying two or more higher strike Out-of The-Money call options. The backspreader is seeking a dramatic move in the underlying. The strategy will benefit greatly if the underlying rallies big, due to the extra long call(s), but it can also profit if it falls hard. These trades can be generally accomplished for even money or a credit depending upon the prices of the options and the strike selection. The long calls are for price appreciation, while the established credit hedges the downside.

Let’s look at an example:

SLF (Sun Life Financial) is trading at C$54.56 as March 9, 2018. The investor believes it will either fall below $54.65 or above $57.35 by 04/20/2018.

The investor sells a April 54 strike call for C$1.45 while buying three April 56 calls for C$0.40 (C$1.20 total). The credit is established for C$.25 (C$1.45-C$1.20=C$0.25).

Short 1 SLF April 20 expiry 54 Call + Long 3 April 20 expiry 56 Calls – SLF trading at C$54.56

Note, the maximum loss could occur at expiration with the underlying price trading at C$56 and Out-Of-Money calls worthless (C$1.75)

The maximum gain on the downside is the established credit or C$.25 while the maximum profit is unlimited!

The Break-Even is with the underlying closing at C$56.88 at expiration (C$.01)

The risk of early assignment exists for the In-The-Money short call option. This will not change the limited risk nature of the strategy prior to expiration as the investor is covered by the long options. However, at expiration the investor will want to close the strategy to avoid being naked short shares and additional margin requirements.

The Ratio Backspread is disadvantaged by the time-decay as the Out-The-Money long options are all composed of time value. Any increase in volatility has a positive effect, while any decrease in volatility is negative for this strategy. Tactically speaking, the strategy should be placed when volatility is historically low and the investor expects a huge volatile move in the underlying.

The Ratio Call Spread can also be constructed as a delta-neutral spread. In the example above, the delta for the April 54 Call is .6380 with a .3272 delta for each of the three April 56 Calls. The delta neutral ratio would then be 1.95:1, derived by dividing delta of the 54 call by the delta of the 56 call (.6380/.3272). The investor, in this case, would buy with a 2:1 ratio 4 of the 56 calls while simultaneously selling 2 of the 54 calls. A delta neutral strategy keeps the strategy from being either too bullish or too bearish. Remember, deltas and additional options Greeks can be found at https://www.m-x.ca/marc_options_calc_en.php

We will delve deeper into delta and gamma neutral trading in a later piece.

It is essential to point out that this strategy needs to be actively Managed, so it is only suitable for investors with ample options trading experience.