An Introduction to Ratio Backspreads

At their most basic level, a call spread is a bullish strategy while a put spread is a bearish strategy. The call ratio backspread involves selling a number of calls at one strike and then buying more calls at a higher strike price. The strategy can also utilize put options by selling a number of puts at one strike and then buying more puts at a lower strike price to form a put backspread. In either strategy, all of the options involved should have the same expiration date. The risk in a ratio backspread is limited, while the reward is unlimited.

A typical call ratio backspread involves selling one call at one strike and buying two calls at a higher strike price. It could also be set up using other combinations as long as the ratio remains at 2-to-3 or less (selling two calls and buying three calls for example). The goal of a call ratio backspread is to profit from a bullish predicting with the sold calls partially offsetting the cost and impact of time erosion. The put ratio backspread would profit from a bearish prediction.

If structured properly, proceeds from the sale of the options 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. A put ratio backspread is the exact inverse, i.e., sell one (or two) puts and buy two (or three) puts at a lower strike price.

While a call spread 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 if set-up correctly. Since you need a significant move in the underlying stock, it makes sense to look for potential catalysts that can get the stock moving in one direction or another.

Call Ratio Backspread Example:

• Equity XYZ trading at $50
• Two at-the-money 50-strike calls purchased at $2
• One 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 50-strike calls expire worthless, and the investor will have to repurchase the 45 call for five points, or $500 per contract. This results in a net loss of 4, or $400 per contract ($500 less the initial credit of $100).

This call ratio backspread will always have two breakeven points.

The lower breakeven point for a call ratio backspread:

• Lower strike + (credit received divided by number of contracts sold)

The upper breakeven for a call ratio backspread:

• Higher strike + (Number of contracts sold * difference in strike prices) – credit received

The lower breakeven point for a put ratio backspread:

• Lower strike – (Number of contracts sold * difference in strike prices) – credit received

The upper breakeven for a put ratio backspread:

• Higher strike - (credit received divided by number of contracts sold)

Thus, a ratio backspread has a theoretically unlimited profit potential for calls and a substantial profit potential for puts. Meanwhile, losses are capped in this strategy to (the difference in the strike prices multiplied by the # contracts sold) less the premium (credit) received, if any. Given there are two profit scenarios, there are also two possible breakevens (an upper and a lower).

The ratio backspread is one of several strategies covered in Schaeffer's Mastering Advanced Option Strategies^SM.