Ratio Call Spread Strategy in Equity Options
The ration call spread strategy which is used in equity options trading, is appropriate for investors believe a market will be undergoing a slight rise, therefore there is a potential for selling. So the trader purchases a call option, and sells mulpiple call options with a higher strike.
If the share price is at the higher strike price of the spread at expiry, the maximum profit point will be reached. The possibility for profit depends on how many calls have been sold versus calls bought. Generally the ratios are opened on a 1:2 basis and rarely higher than 1:3 due to the increased risk this would introduce if the shares happen to rise strongly.
In the case of the shares falling, the investor can lose the cost of the spread in the worst case. This protection against a fall in the price of the shares is greater than in the case of a bull call spread because of the higher number of written positions in place. If a strong upward movement occurs unexpectedly the investor could face huge losses. The higher the number of unprotected calls that have been sold, the larger the loss that could be suffered.
Ideally the spread is opened for a profit, which involves no risk if the shares fall.
There are ways for traders to try and protect their positions for major losses
Market strengthens: the ratio call spread provides good protection for the investor in the event of a market downturn. The negative side of this protection, is that the trader could suffer big loss if the market moves higher than expected.
Exercise: because the strategy involves uncovered written positions, the risk of exercise must be considered. The trader must meet the collateral requirements of the uncovered calls.
The main threat to the ratio call spread comes from big up rise in the market which was not expected. If this happens, the trader has the option to close out the spread, or close out the sold options to reduce the risk of exercise.
If the share price falls dramatically, the trader may buy back the long call before it loses too much time value. The danger in closing out the long position is that a market reversal leaves the trader totally exposed on the short legs.
This strategy benefits from a small upward movement in the market. It should not be used if a strong upward movement is expected.