- 1999: Volume 8, No. 6 Call Ratio Backspread

The Call Ratio Backspread is a hedged, directional trade in which we profit from a strong upward movement-similar to a straight call position-while protecting our downside. If we are wrong and the market moves against us, we either do not lose or may even move into a small profit zone.

Strategy Snapshot
Outlook: Risk: Reward: Time Frame: Trade Type: Volatility:	Very Bullish Limited Unlimited 2 Months+ Credit/Even Medium/High

Structure of the Trade

The structure of the trade is the shorting of lower strike calls while buying multiples of higher strike calls. Typically, we want to enter at even or for a credit.

If we are correct and profit in a strong upward movement, we can close the trade prior to expiration to avoid assignment of the short calls. If we are wrong and the market moves against us, we can exit or ride the trade out to expiration-possibily with a profit. The risk is also buffered in the interim stage of the trade if we decided to exit early.

To best illustrate the concept of a Call Ratio Backspread, we will use basketball players' contracts as an analogy.

We sell a contract on a basketball player (this will be like selling a call option). The player we are going to use is Magic Johnson. When Magic was in his prime, his contract was very expensive. When we sell that contract we take cash in. Understand, we do not own his contract: we do not need to in the financial markets.

Rather than putting all that cash in our pocket, we reinvest it, purchasing a contract, picking, in this case, Michael Jordan when he was a rookie.

Obviously, we can afford to buy more than one Michael contract when he is still a rookie with the money from Magic's contract. In this analogy, we are buying two Michael contracts from the one Magic contract that we sold. There might be money left over. If so, we would put it in our pocket.

Let's take a look at how this plays out. If Michael's value goes up, we make money from owning two of his contracts. If Michael's value goes down, we still do not lose because we paid for Michael's contracts by selling Magic's contract. We possibly had even put some change in our pocket.

How does this apply to the financial market? In entering this trade, we sell a lower strike call. From the money received, we simultaneously buy two higher strike calls. Whatever cash is left over from selling the lower strike call and buying the higher strike calls will be credited to our account. Now, let's evaluate the trade with the following three market conditions:

Stock moves down—Since we are in long and short call positions, if the stock drops in value, both the short and long contracts go down in value. They will both move, not necessarily precisely together, but they will move in the same general direction. If both positions drop in value and expire worthless, we lose nothing. In fact, we took in a small credit. This is why we are typically looking for opportunities to enter this trade at even or better.

Stock Moves Up—The second consideration is if the stock goes up in value. We have one position that we have shorted and two positions in which we have gone long. As the stock goes up, the position that we shorted will likewise go up, which is a negative to us. However, the two positions that we bought will make money at a faster rate than the position that we have sold because we own two of them for each one that we sold. This gives us an unlimited upside-as high as the stock goes.

Stock Stays the Same—If the stock does not move or stays directly on the strike that we bought, the short position will have intrinsic value. While the position that we are long will be worthless, the value in the short position will be our loss. It can be no greater than the spread between the two strike prices minus whatever credit we took in when we entered the transaction.

Finding the Right Stock

In a Call Ratio Backspread, we typically look for volatile stocks that will have fairly significant upward movement. Indicators that could be effectively applied to a Call Ratio Backspread might be earnings reports, potential changes in interest rates, pending litigation outcomes, etc.

Our probability of winning is better than most speculative trades since our profit zones are both on the upside and downside of the stock movement. We anticipate an upward move with a strong hedge if we are wrong.

Case Study

The best way to understand a Call Ratio Backspread trade is to work through a case study. We will use Cisco (CSCO).

Cisco Systems (CSCO)			55 3/8 10/16/98
Exp	Calls	Bid	Ask
Jan Jan Jan Jan	50 55 60 65	9 5/8 6 3/4 4 1/4 2 5/16	9 3/4 6 7/8 4 3/8 2 5/8

Figure 1 contains a 1-by-2 Call Ratio Backspread for CSCO January 50 and 60 Calls. The graph illustrates the risk profile at expiration date.

Entry:

Buy 10 contracts of Jan 60 Calls
Sell 5 contracts of Jan 50 Calls

Entry Cost:

4 3/8 * 2 - 9 5/8 = -7/8
(7/8 of credit on entry)

Maximum Reward:

On the Upside: Unlimited
On the Downside: 7/8
(Entry credit is the maximum downside reward.)

Maximum Risk:

Maximum reward is when by expiration, the stock stays exactly at the long call strike price ($60).
Maximum Risk = Difference between the strikes of what we sold and bought, minus original credit of the trade
Maximum Risk = 60 - 50 - 7/8 = 9 1/8

Breakeven Point:

Lower Breakeven = Lower call strike + credit received = 50 + 7/8 = 50 7/8
Higher Breakeven = Higher call strike + Maximum Risk = 60 + 9 1/8 = 69 1/8

The benefit of this trade is the unlimited upside. If the stock drops below our short call price, we also have a limited profit (assuming we enter at a even or for a credit).

What is the Correct Ratio in a Call Ratio Backspread?

Typically, most traders place a 2:1 (ratio of 2) or a 3:2 (ratio of 1.5). This ratio can vary depending on the size of contracts. As a rule of thumb, a 3:2 is as low as we will consider. For example, a 7:4 (ratio of 1.75) is a still a viable Call Ratio Backspread choice. One key to remember in any spread trade: we will never enter any position that has more short contracts than long contracts!

How do different ratios affect the risk graph? The graphs in Figure 2 are both for CSCO January 50 - 60 Call Ratio Backspread trades. One is a 2:1 ratio while the other one is a 3:2 ratio.

The graph shows that a 2:3 ratio provides more credit on the downside than a 1:2 ratio; however, its window of risk is much narrower than the 1:2.

Evolution of Trade Over Time

Upon entry, the Call Ratio Backspread risk graph looks similar to a Call Option with a smaller range of loss.

As the position evolves over time, the long Call option strike price dips more. As time progresses toward expiration, this dip gradually deepens, eventually maturing into "V" shaped lines.

Ideally, we do not want to hold this position until expiration day. To limit our risk and use the benefit of the initial lower risk profile, we will exit before too much depletion due to time decay. Generally speaking we will not be in a Call Ratio Backspread more than 50 percent of the time that we have bought. Another rule of thumb is to typically exit the trade one month prior to the expiration date.

Volatility Impact

It is ideal to enter upon low volatility with the anticipation of a fairly significant increase. If the current volatility is too high, it will be difficult mathematically to place the trade at even or for a credit. A rise in volatility will swell profits and further limit risk.

We typically don't enter with less than a 3:2 ratio. A 2:1 ratio is better and a 3:1 is better still.

As volatility picks up, the risk curve will become a sharper, upward curve with less of a dip at the long strike price. If volatility goes below our current entry point, we will begin to see a deeper dip. This dip will not be at maximum until expiration when the time premium completely depletes.

Summary

The value of this trade is multifold. We are entering a trade that does not take any of our own money (although there is a margin requirement), such that if the stock goes up in value we have an unlimited upside reward, and if the stock goes down we still walk a way with a little profit. The only risk is if there is no movement and even then the risk is manageable.

Check List for Entering

1. Minimum of 3:2-Long vs. Short Ratio
2. Looking for even or credit net on entry
3. Buy as much time as possible
4. Smaller the spread, the narrower the window of risk
5. Expecting a big rise in stock movement
6. Take close consideration of timing on entry and exit

ITEM 1: Ratios other than 1:2 are possible. For instance, one could sell two lower strike calls contracts and use that cash to buy three higher strike call contracts.

The higher the ratio of the Call Ratio Backspread, the narrower the window of risk will be (distance between the two breakeven points). In addition, the higher the ratio, the faster the upside gain will be.

Because of this, a lower than 3:2 ratio requires significantly more stock movement to profit. Ideally the higher reward-to-risk ratio, the better. 3:1 being the ideal, we usually look for positions that have a 2:1 ratio.

ITEM 2: Typically, if entry is not even or better, this will not be an attractive trade.

ITEM 3: In entering a Call Ratio Backspread, we are buying more time than we sell, and there comes a point when it is mathematically impossible to go beyond a certain time frame and still get an even or better net at entry.

That time frame depends on multiple factors including volatility, where the stock is and what strike prices we are using. In general, we want to buy as much time as we can that will still allow us to enter at even or for a small credit.

ITEM 4: The wider the spread, the bigger the window of risk. For example, assume we entered a 2:1 net-even Call Ratio Backspread. A $5 spread will have ten points between the two breakeven points, while a $10 spread will have twenty points between the two breakeven points. We have a much greater likelihood of winning with a smaller window of risk.

ITEM 5: In this position we are either playing a strong trending stock or expecting a big move because of a pending event, while simultaneously hedging our downside. We are typically looking for a highly volatile stock.

ITEM 6: We want the longest time frame possible while maintaining an even or better net entry, with the typical time frame at two to three months. Sometimes we can even find good LEAPS candidates. We will structure the trade around available news, events or indicators and also allow ample time to exit if the stock does not perform as expected. By carefully planning the structure, we will limit our exposure as much as possible, since most of the risk is due to time decay in the last phase of the option timeline.

Rance Masheck of Quantum Vision developed the Spread Trader Edge System which reveals Inside Floor Traders and Money Managers' Spread Trading secrets to the general public. Quantum Vision specializes in educational seminars that teach strategies that profit in any market condition regardless of market direction. By utilizing the power of Spread Trading, they show you how to structure the most optimal trades, limit your risk and dramatically elevate your winning probability. One of the strategies Rance teaches in his options trading seminar is the Call Ratio Backspread.