Bull Spread - Long Call Ratio Spread

Bull Spread

Long Call Ratio Spread

While this is a Bull Spread option strategy, it can be a market neutral to bullish bias and non directional option strategy.

When to use : Neutral to Bullish Trend
How to establish : LONG 1x Call and Short 2x Call
Debit or Credit : Credit (preferably)
Margin Requirement : Yes
What is the Maximum Profit : Limited to between the Long and Short strikes
What is the Maximum Loss : Unlimited

Example :

Starbucks (SBUX) is trading at $15. You believe that their recent cost cutting measures will optimise their operations by lowering costs and perhaps even increasing their margins. However, you think that SBUX could stay range bound with a possible rally when it reports earnings in Sept. But the upside to SBUX price should have a ceiling in the near term with such uncertainty in consumer spendings.

Again, because we are now in Sept and the Oct Call options will be expiring in a month's time, you do not wish to be disadvantaged by Theta (the greek for time decay). Theta is most aggressive for options with ~30 days remaining to expiration. You want a strategy that will mitigate losses resulting from theta and also since you opine a upward limit to where SBUX price will go to, you then establish this option strategy :

Long 1x SBUX Sept15 Call and Short 2x Sept 16 Call - this is known as a Long Call Ratio Spread

This position is similar to a Long Call Spread, with an added Short OTM Call; meaning, in our example,

Long SBUX Oct15Call and Short Oct16Call (which is a Long Call Spread) and added Short Sept16Call

The Short Calls position is established mainly for 2 reasons :
a) To compensate you for the loss due to time decay, as Short options earns you time value whereas Long options penalizes you Theta.
b) You believe that SBUX will NOT head much higher


Note here, that the contract size of the Short position is 2 times of the Long position. This is known as a 1 x 2 ratio spread. You could, if you choose to, establish a 1 x 3, 1 x 4, 2 x 5, or any other contract size combinations but the size of the Long position is always smaller than the Short position. More importantly, the bigger the multiplier of the Short option, the bigger the assumed risks. Hence, a 1x4 Ratio Spread has a bigger risk component than a 1 x2 or 1 x3 Ratio Spread.

Special Note : Ratio Spreads can start by having a -ve Delta, or a small +ve Delta, even though this is considered a Bullish Spread. Recall that you always want large +ve Deltas for bullish position

A simple way to look at a Long Call Ratio Spread, is this. It is a Long Call position, where the premium paid to establish this bullish position, is entirely funded by the multiple Short OTM Call positions. This ratio spread, should be established for a NET credit, or it will not be justifiable for assuming the associated risks of unlimited losses.

In our example, Oct15 Call is priced at 1.15 and the Oct16Call is trading at 0.63. By buying ONE Oct15Call and selling TWO Oct16 Calls, you will receive a NET credit of 0.11 ( 2 x 0.63 - 1.15). This means, you are actually paid to trade this position.

In this SBUX example, these are the following 2 Greeks:
Delta = -ve 0.24
Theta = 1.07

A -ve delta for a bullish position is no good. The reason is that even for a 1 point increase in SBUX price, this ratio spread is effectively losing money because the -ve delta will reduce the spread's value. The good news is, this -ve delta will have a chance of turning into a +ve delta. This effect can be caused by the passage of time and SBUX price. The inter-relationship between Greeks is a rather complex topic, which I will hope to cover in a separate post.

A +ve theta is always a good cheer. As time passes, even if SBUX price remains stationary, you add 1.07 to your ratio spread value everyday. This +ve theta value increases over time.


Profit/Loss Explanation :

(you will have to assume these option prices are correct)
Debit for (ONE contract) Long Oct 15 Call = -1.15
Credit for (TWO contracts) Short Oct 16 Call = 1.26 (2 x 0.63)
Total Credit = 0.11

Maximum loss : unlimited
Maximum profit : 1.11 ( 16strike - 15strike + 0.11 credit)
Breakeven point : 17.11
Profitable range : SBUX trades below $17.11 at expiration
Risk/Reward Ratio = if SBUX rallies to the stars, then this ratio is unquantifiably high.


The breakeven point is 17.11. The maximum profitable spread is $1 (16strike - 15strike) because you have a right to buy SBUX at $15 and you are obligated to sell it at $16, should SBUX trade above $16 anytime before and up to Oct expiration date. If this happens, you now have $1 profit as your cushion if this spread moves against you subsequently. The value of this spread peaks when SBUX is trading at $16 at expiration.
In this case, should SBUX continue to rally from $16 to $17, you are now losing $1 because of the additional Short Oct16 Call. You then use the $1 you made to pay for this $1 of losses. You can afford to let SBUX rally until $17 without incurring a loss yet. Remember, when you put in this trade, you received $0.11 credit. Therefore, your actual breakeven point is when SBUX is trading at $17.11 at expiration (not before and not after but exactly at expiration).

If SBUX trades below $15 at Oct expiration date, all the 3 Call options of this ratio spread will expire worthless and you keep all the credit received; ie 0.11 The reason that this spread will expire worthless is this. No one will exercise the Short Oct16Calls, because no one will want to buy SBUX for $16 when it is now trading below $15. Likewise, you will not exercise your Long Oct15 Call and buy SBUX at $15.

Hence, a Call Ratio Spread, allows a trader to profit, in these scenarios :

a) when the underlying rallies up to just before breakeven point
b) when the underlying stays unchanged by expiration
c) when the underlying drops in price, modestly or even to $0 value

This Call Ratio Spread is profitable in just about all possible price movements, except for a sudden and major gap up beyond the breakeven point. Then, in this case, the losses can be theoretically unlimited.

Hence, for most seasoned traders, Ratio Spreads is always among the arsenal of option strategies they employ.


+1/-2 SBUX 15/16 Call Ratio Spread P/L Chart