A call ratio spread is a multi-leg, neutral strategy with undefined risk and limited profit potential. The strategy looks to take advantage of a drop in volatility, time decay, and little or no movement from the underlying asset.
Call ratio spreads have three components: one long call purchased in-the-money and two short calls sold at a higher strike price out-of-the-money. The short calls will have the same strike price. All three call options have the same expiration date. Call ratio spreads may be opened for a debit or a credit, depending on the pricing of the options contacts, but call ratio spreads are typically established for a credit. Ideally, the stock price closes at the short call strikes at expiration.
Call Ratio Spread market outlook
Call ratio spreads are market neutral to slightly bullish. The strategy depends on minimal movement from the underlying stock to be profitable. To reach maximum profit potential, the underlying stock price would need to rise in price to close at the short strike prices at expiration. Therefore, a slightly bullish bias is an appropriate outlook for a call ratio spread.
If the call ratio spread is initiated for a credit, the profit potential is the amount of credit received plus the width of the spread between the long and short call options. However, if the underlying stock price falls below the long call option, a profit will still be realized. All options would expire worthless, and the initial credit received would remain. Call ratio spreads have undefined risk if the stock price experiences a significant move higher above the short calls.
A call ratio spread is used when the underlying asset is expected to stay within the range between the two strike prices before expiration.
How to set up a Call Ratio Spread
A call ratio spread is a bull call debit spread with an additional call sold at the same strike price as the short call in the spread. The bull call spread results in a risk-defined position with limited profit potential. The goal is for the stock price to close at the short strikes at expiration. This results in the short contracts expiring worthless, and the long call could be sold with the maximum intrinsic value.
If the underlying stock price drops below the long strike, all options expire worthless, and the maximum loss is limited to the debit paid or, if a credit was received at trade entry, the credit will be realized as a profit. However, because of the single naked call, if the underlying asset’s stock price exceeds the short call options, the risk is unlimited.
The debit paid or credit collected at entry will depend on how far in-the-money the long call option is and how far out-of-the-money the short call options are relative to the underlying’s stock price.
Call Ratio Spread payoff diagram
The call ratio spread payoff diagram illustrates the strategy’s different outcomes based on the underlying stock price. Ideally, the stock price closes at the short strike options at expiration. When a call ratio spread is entered, there is potential for either paying a debit or receiving a credit.
If a credit is received, the amount collected, plus the width of the strike prices, is the maximum potential profit for the position. If a debit is paid, the maximum potential profit is the width of the spread between the short and long strikes, minus the amount paid to enter the position.
Maximum gain and loss are limited if the stock price falls below the long call option. All contracts would expire worthless, and the premium paid or received at entry will remain for a profit or loss. Maximum loss is unlimited if the stock price exceeds the break-even point above the short calls.
For example, if a stock is trading at $52, a call ratio spread could be entered with one long call at $50 and two short calls at $55. Assume a $1.00 credit is received. If the stock closes at $55 the maximum profit potential is realized. $600 is the most that can be made on the trade (the width of the spread, $5, plus the $1.00 credit). The short calls would expire worthless, and the long call can be sold for $5, plus the initial $1.00 credit. If the stock closes at $61 on expiration, the short calls will cost $12 combined to exit, but the long call will be worth $11.
Because the position received $1.00 at trade entry, the position will break-even at expiration if the underlying stock is trading at $61. If the stock closes below $50, all options will expire worthless and the original credit of $100 will remain. If the stock closes above $61, the potential loss is unlimited.
Entering a Call Ratio Spread
A call ratio spread is a bull call spread with a naked call option sold at the same strike price as the short call option in the spread. Call ratio spreads consist of buying-to-open (BTO) one in-the-money long call option and selling-to-open (STO) two out-of-the-money short call options above the current stock price. All options have the same expiration date.
The amount of contracts is variable, but the most common ratios are 2:1, 3:2, and 3:1. For example, if a stock is trading at $52, a call ratio spread could be entered with one long call at $50 and two short calls at $55.
Entering a call ratio spread may result in receiving a credit or paying a debit. The premium depends on multiple factors, including the width of the spread, how far in-the-money and out-of-the-money the options are, and implied volatility skew. For example, if the marketplace perceives an asset to be very bullish in the future, out-of-the-money options may be more expensive than normal, relative to the in-the-money option.
Exiting a Call Ratio Spread
A call ratio spread will experience its maximum profit potential if the stock price is exactly the same as the short strike options at expiration. In this scenario, or if the stock price closes below the short options and above the long option, the short call options expire worthless. The long call option that is in-the-money may be sold.
If the stock price closes below the long call option, all three options will expire worthless, and no further action will be needed. If the stock price closes above the short call options, all three options will be in-the-money and need to be closed if exercise and assignment are to be avoided.
Time decay impact on a Call Ratio Spread
Time decay, or theta, works in the advantage of the call ratio spread. Every day the time value of an options contract decreases, which will help to lower the value of the two short calls. Ideally, the underlying stock experiences minimal movement, and theta will exponentially lose value as the strategy approaches expiration. The decline in time value may allow the investor to purchase the short options contracts for less money than initially sold, while the in-the-money long option will retain its intrinsic value.
Implied volatility impact on a Call Ratio Spread
Call ratio spreads benefit from a decrease in the value of implied volatility. Lower implied volatility results in lower option premium prices. Ideally, when a call ratio spread is initiated, implied volatility is higher than where it will be at exit or expiration. Lower implied volatility will help to decrease the value of the two short calls more rapidly. Future volatility, or vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the pricing of the short options.
Adjusting a Call Ratio Spread
Call ratio spreads may be adjusted before expiration to extend the trade duration or alter the ratio in the spread. If the underlying security rises and challenges the short calls, buying additional long calls to reduce the call spread to a 1:1 ratio caps the position’s risk. Adjustments will most likely come with additional cost to the position, which will increase the risk, lower the profit potential, and narrow the break-even points. Furthermore, because call ratio spreads consist of two short contracts, assignment is a risk any time before expiration.
External factors, such as dividends, may need to be considered when deciding to adjust or close a call ratio spread position. If an investor wants to avoid assignment risk, and/or needs to extend the trade into the future to allow the strategy more time to become profitable, the entire position can be closed and reopened at a future expiration date with the same, or new, strike prices. Typically, if the stock moves above the break-even point, the position is closed instead of adjusted.
Rolling a Call Ratio Spread
Call ratio spreads require the underlying stock price to be at or near a specific price at expiration. If the position is not profitable and an investor wishes to extend the length of the trade, the call ratio spread may be closed and reopened for a future expiration date. Because more time equates to higher options prices, the rollout may cost money and add risk to the position, depending on the initial credit or debit of the spread.
If the stock price has moved above the short call options, there may be an opportunity to close out the existing position and enter a new spread with new strike prices closer to the underlying asset’s current price. However, doing so would not make sense if the new net debit paid exceeds the spread's width, as the position would no longer be profitable.
Hedging a Call Ratio Spread
The most common hedge for a call ratio spread is the purchase of additional long calls to reduce the spread ratio. Purchasing additional long call options converts the call ratio spread into a bull or bear call spread, depending on the outlook for the security at the time of the hedge. Protection from lower movement in the underlying stock is not necessary because the long call option has defined risk to the downside.
However, if an investor wants to protect against a significant increase in the stock price, a long call option may be purchased above the short strikes. This would effectively create a bear call spread and protect against an increase in the underlying stock price. If the stock moves above the break-even point, the position may be closed instead of hedged.
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