Involving multiple options and both buying and selling, ratio backspreads are relatively complex strategies employed by investors who expect a big move, are relatively sure of the direction, but still want to limit their risk. The strategy is structured to allow for sizeable profits (unlimited in the call direction) if the investor's projections on timing and direction are correct. If the directional prediction is incorrect, the trader can break even on the trade or even book a small profit.
Call and Put Ratio Backspread Basics
The call ratio backspread, executed if one is bullish on the underlying stock, index, or exchange-traded fund, involves selling a number of calls at one strike and buying more calls at a higher strike price (typically, a 1:2 or 2:3 ratio is employed, but the ratio is always 2:3 or less). The position entered is bullishly aligned because more higher-strike (out-of-the-money) calls are purchased than lower-strike (in-the-money) calls are sold. The bullish prediction is modestly offset by the sold calls, which alleviate the cost burden and help compensate for the impact of time decay.
A put ratio backspread is the exact inverse. In this bearish strategy, the options trader would sell a number of puts at one strike (probably in the money) and then buy a larger number of puts at a lower, out-of-the-money strike. In both call and put backspread situations, all of the options involved should have the same expiration date.
If a ratio backspread is structured properly, proceeds from the options sold will match or exceed the price of the purchased options and create a hedge. This "hedge" allows a trader to book a small profit or break even in the event that the trade moves against him. The tradeoff is that the upside break-even point is higher compared to the outright purchase of a call that is "naked" (unhedged by a stock position or another option).
While a call backspread is a bullish strategy that yields significant profits from a major upside move, it can also produce a (limited) profit on a strong bearish move as well, if constructed correctly.
Call Ratio Backspread Example:
- Equity XYZ trading at $50
- 2 at-the-money 50-strike calls purchased at $2
- 1 in-the-money 45-strike call sold at $5
- Net credit of $1 (or $100) per contract [$5 – (2*$2)]
If XYZ is trading below $45 at expiration, both option positions expire worthless and the trader pockets the credit received at the time of execution ($1, or $100, per contract). Thus, a spreader can benefit even if the underlying stock moves against his expectations. However, upside profits are theoretically unlimited since the investor is long more calls than he is short.
The maximum loss in this example occurs if the underlying stock closes right at $50 (the higher, or purchased, strike price) at expiration. The purchased 50-strike calls expire worthless, and the investor will have to repurchase the 45 call for 5 points, or $500 per contract. This results in a net loss of 4, or $400 per contract ($500 less the initial credit of $100).
Put Ratio Backspread Example:
- Equity XYZ trading at $50
- 2 out-of-the-money 45-strike puts purchased at $1
- 1 at-the-money 50-strike put sold at $4
- Net credit of $2 (or $200) per contract [$4 – (2*$1)]
If XYZ rises closes at the strike of the sold put (50), both options expire worthless, allowing the investor to pocket the $200 credit. If the stock does drop in price (ideal for a put trade), the profit potential is large because the investor is long more puts than he is short.
The maximum loss occurs if the underlying stock closes at 45 at expiration (the lower, or purchased, strike price). At this point, the purchased 45 puts expire worthless and the trader will be required to buy back the 50-strike put for 5 points ($500 per contract) or purchase the stock at $50 with the shares trading at $45. This results in an overall net loss of 3, or $300 per spread ($500 less the initial credit of $200).
Given there are 2 profit scenarios, there are also 2 possible breakevens (an upper and a lower) for ratio backspreads.
The lower break-even point for a call ratio backspread:
- Lower strike + (credit received divided by number of contracts sold)
The upper break-even point for a call ratio backspread:
- Higher strike + (Number of contracts sold * difference in strike prices) – credit received
The lower break-even point for a putratio backspread:
- Lower strike – (Number of contracts sold * difference in strike prices) – credit received
The upper break-even point for a put ratio backspread:
- Higher strike - (credit received divided by number of contracts sold)
A ratio backspread has a theoretically unlimited profit potential for calls and a substantial profit potential for puts (theoretically, until the underlying stock hits zero). Meanwhile, losses are capped in this strategy to the difference in the strike prices multiplied by the number of contracts sold) less the premium (credit) received, if any.
The best time to initiate either call or put ratio backspreads is during times of market volatility (or at least volatility on the targeted stock or ETF). Look for potential catalysts that can send the stock moving in one direction or the other. Examples include earnings reports, corporate restructuring, or product approvals.
Ratio Backspread Disadvantages:
Massive profit potential, limited risk, and the chance to break even or even profit slightly if your call is wrong? The ratio backspread may sound like a win-win, but it does have its cons as well. Commissions are steep, as an investor will incur a minimum of 3 commissions to enter a backspread trade. Depending on the results, he or she can also pay several commissions to exit the spread.
The worst-case scenario ends with the investor having to acquire the stock above its current market value or sell the stock below its market value. Finally, ratio backspreads do not work well in trading-range environments, as the best trades will result from a sharp move in the underlying stock.
