The Call Ratio Spread is a neutral-to-bearish Options strategy where you buy and sell Call Options at different strike prices with different ratios to create a net debit or credit.
If you have more Short Calls than Long Calls, you’d receive a net credit and that’s called a Front Ratio Spread.
If you have more Long Calls than Short Calls, you’d pay a net debit and that’s called back Back Ratio Spread.
As premium sellers, we generally only want to utilize the Front Ratio Spread as that gives us the highest win rate.
So for the rest of this post, we will focus on the Front Ratio Spread.
So do you set up the Call Ratio Spread?
When do you put it on?
And exactly how do you trade it?
The Call Ratio Spread Risk Profile
The above image shows the risk profile using:
- One Long Call (OTM)
- Two Short Calls (further OTM)
This is commonly referred to as a one-by-two ratio (1:2).
Depending on your risk tolerance, you can go by different ratios.
For example, you might construct a one-by-three ratio (1:3) where you would have more risk to the upside, but you’d receive a bigger net credit.
This strategy has an unlimited risk to the upside and limited profitability to the downside.
As the market goes up, the profit potential also increases where there is a “tent”.
That’s where the Short strikes are.
So if the market lands exactly at the Short strikes at expiration, you will get the max profit.
Also, it is a high-probability strategy.
The above is constructed using the 20-delta Short Call strikes.
For the Long Call, it’s adjusted so the overall net credit is around $0.50 (which equals to $50 per spread).
But it can be adjusted based on your view of the underlying stock.
If you’re more bearish, you can adjust it so that you receive more overall net credit.
But this will reduce your max profit potential.
If you’re more bullish, you can adjust the Short strikes to a lower delta.
This way the “tent” would be further OTM.
Similarly, you could also adjust the Short strikes to a higher delta.
By doing that, the “tent” would be closer to where the current market price is.
As you can tell, this strategy is very flexible in its construction.
The Call Ratio Spread can also be seen as a combination of two strategies:
- Short Call
- Bull Call Spread (aka bullish debit vertical spread)
The idea here is to use the premium collected from the Short Call to finance the purchase of the Bull Call Spread.
This way it will be for an overall net credit.
So even if the market tanks, you will at least still profit from the premium you receive for selling it.
How To Trade The Call Ratio Spread
There are three ways to trade this strategy:
- Naked Call Ratio Spread
- Covered Call Ratio Spread
- Double Ratio Spread
The Naked Call Ratio Spread
If you do not have at least 100 shares of the underlying stock, then it would be considered a Naked Call Ratio Spread.
That’s because you still have the Naked Call component.
That means if the market shoots to the moon, you could lose a lot of money on this strategy.
However, that does not mean it’s a bad strategy.
If you know when to put it on, you can reduce its risk dramatically.
For example, if you put on this strategy when the market is overbought, there’s a lower probability the market would continue going up.
But one thing to take note of is that most equities and index ETFs have Put skew.
That means the Options at the lower strike prices have higher volatility.
And that would result in the lower strike prices being priced relatively more expensively than the higher strike prices.
With the Call Ratio Spread, you would be selling the higher strike prices and buying the lower strike price.
Hence, the max profit isn’t as big compared to its counterpart – the Put Ratio Spread.
If you were to put on the same 20-delta Short strikes for both spreads, you will find that the Put Ratio Spread would have a bigger max profit potential compared to the Call Ratio Spread.
Hence, it might be better to find stocks where there’s a Call skew to put on the Call Ratio Spread.
This way the max profit potential would be bigger.
The Covered Call Ratio Spread
If you have at least 100 shares of the underlying stock, then it would be considered a Covered Call Ratio Spread.
This is a variant of the Covered Call where you can get more profits if the market goes past your Short Call strikes.
I call this strategy the Enhanced Covered Call.
Apart from the fear of getting assigned, you might have wished you hadn’t sold the Covered Call so early because if you have waited, you could have sold the same Covered Call for a higher premium.
The alternative to the Covered Call is the Covered Call Ratio Spread.
This way you’d be more profitable if the market went up.
That’s because of the embedded Bull Call Spread.
So if you’re worried about the market going up, then selling the Covered Call Ratio Spread might be better than just a Covered Call.
The Double Ratio Spread
The Double Ratio Spread is when you combine both the Call Ratio Spread and the Put Ratio Spread.
This is similar to the Short Strangle, except without the embedded debit spreads.
By trading both Ratio Spreads together, you’re able to get a bigger net credit.
Furthermore, it has many profit zones.
If the market goes sideways and does not enter the “tent” on either side, then you would keep the full premium of the Double Ratio Spread.
If the market goes up, you will have a chance of hitting the max profit potential of the Call Ratio Spread.
And if the market goes down, you will have a chance of hitting the max profit potential of the Put Ratio Spread.
It’s the best of both worlds!
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