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One of the ways to participate in the Indian stock market is through derivatives trading, in which investing in option contracts is the most popular one.
Options trading can be done in various ways, such as buying or selling a single option contract or combining multiple options contracts to create a more complex strategy. One of the option trading strategies that can be used in the Indian market is the call ratio spread.
With this technique, the underlying asset fluctuates barely or not at all, and there should be a decrease in fluctuation and time decay. A bullish trading strategy in the options market that includes trading call options is known as call ratio backspread.
In this article, let’s look into the concept of call ratio backspread in detail.
What is the call ratio backspread?
The concurrent buying and selling of call options is the basis of the call ratio backspread option approach. The strategy aims to make the most money possible shortly from a sizable increase in the underlying stock’s price. It can reduce risk and preserve infinite profit potential by combining purchased and sold options.
With this approach, you buy two call options that are OTM and sell one that is ITM and has the same expiry and underlying security.
Here’s how the call ratio back spread approach is put into practice:
- You write down (sell) one call option with a strike price lower than the others.
- You purchase two options with comparatively higher strike prices.
When anticipating a significant increase in the underlying securities, bullish investors employ this method to limit losses.
What makes the call ratio backspread strategy up?
- Ratio: There are two long call options and one short call option in the 2:1 ratio used in this approach.
- Same expiry date: To give you enough time to profit from the position, all of the call options in the approach need to have one expiration date.
- Strike selection: For long positions, you can usually pick an OTM call option; for short positions, you can often choose an ITM call option.
- Bullish view: Investors with a bullish perspective and expect a large price gain in the underlying securities will use this technique.
How to set up a call backspread?
In call ratio backspread, a 2:1 ratio of long and short call options is used for longer-term or next-month options.
One short call option would necessitate two long call choices. When a trade is launched for credit, the most significant loss can be incurred if the long call option’s strike price is reached at expiry.
This happens because the long calls would expire without any worth, and the short calls would be in-the-money. Beyond the long call options, the possibility of making a profit is limitless.
The amount debited or credited at the point of entry is contingent upon the relative distance between the short-term call option’s and the long-term call option’s from the underlying stock value.
Call ratio backspread example:
Below is a call ratio backspread example where the strategy is used in HINDUNILVR.
Call ratio backspread vs. put ratio backspread
Here is a quick summary of the difference between call ratio backspread and put ratio backspread.
| Call ratio backspread | Put ratio backspread |
| This bullish strategy uses longer-term or next-month options and buys a 2:1 ratio of call options to sell. | In this bearish technique, the trader sells one put option and purchases additional put options at a lower strike price in a predetermined ratio. |
| When the contract’s strike price plus the premium paid are equal to the underlying stock price at expiration, the maximum loss happens. | When the price of the underlying stock at expiration exceeds the short put’s strike price less the premium paid, the maximum loss happens. |
| The maximum profit is limitless and arises from a substantial increase in the price of the stock that is being traded. | The capped maximum profit happens when there is a substantial decline in the price of the stock being traded. |
| The break-even point is calculated by adding the net debit to the strike price of the long call. | The break-even point is calculated by subtracting the net credit from the strike price of the short put. |
Conclusion
Only a sharp shift in price brought on by an increase in implied volatility would make the call ratio backspread option strategy profitable. Traders use versions of this method to maximise profitability while boosting trading odds.
However, before using this method, evaluating your risk tolerance and experience with options trading is a good idea.
FAQs
The back ratio option strategy, often used in Indian markets, involves buying more options than you sell. Typically, a trader might sell one option and buy two or three options of the same type (calls or puts) but with different strike prices or expiration dates. This strategy is designed to profit from a significant move in the underlying asset’s price, with limited risk if the move is contrary to the trader’s expectations.
A call ratio spread is a neutral to slightly bullish strategy that involves buying a number of call options and selling a greater number of call options with a higher strike price. The goal is to profit from time decay or a slight increase in the price of the underlying asset while limiting the downside risk. If the asset’s price rises significantly, the strategy can lead to unlimited losses. It’s a complex strategy that requires a good understanding of options and market movements.
The maximum loss on a call ratio backspread occurs if the underlying stock closes right at the strike price of the long call options at expiration. The loss is the width of the spread minus the credit received at entry. For instance, if a trader enters a call ratio backspread using Nifty options, sells one ITM call, and buys two OTM calls for a net credit, the max loss would be the difference between the strikes minus the net credit received.
A 1 by 2 option strategy, also known as a 1×2 ratio vertical spread with calls, involves buying one lower-strike call and selling two higher-strike calls. This strategy is used to profit from a stock price move to the strike price of the short calls with limited downside risk. The maximum profit is realised if the stock price is at the strike price of the short calls at expiration. However, above the breakeven point, the risk is unlimited because the stock price can rise indefinitely.
The butterfly spread is an options trading strategy that combines both bull and bear spreads with a fixed risk and capped profit. It’s designed as a market-neutral strategy, meaning it performs best when the underlying asset’s price remains stable until the options expire. There are different types of butterfly spreads, such as the Long Call Butterfly Spread and the Short Call Butterfly Spread, each with its own method of execution and conditions for maximum profit.