Investors who want to participate in this market can use options to either limit their risk to an adverse move or leverage up on their view of the market.
Today we investigate the Call Ratio Spread Option Strategy which uses options to create a neutral to bullish position. The strategy has the potential to make a profit in all three directions – upwards, downwards and sideways – with limited risk to the downside, but has a mixed risk profile on the upside.
The other day I was asked why we trade options. It’s because options are some of the most flexible trading instruments available to the trader and/or investor. The Call Ratio Spread strategy is established by shorting more out-of-the-money (OTM) call options than the amount of in-the-money (ITM) or at-the-money (ATM) call options that are bought (in order to offset the cost of the bought calls).
It is a limited profit, unlimited risk options trading strategy, that is taken when the options trader thinks that the underlying stock will experience little upside volatility in the near term. Ideally this strategy needs the underlying stock to remain below the short strike for maximum profit potential. The unlimited risk kicks in because your short exposure is not fully covered with the bought call.
A Call Ratio Spread is a vertical ratio spread with the ability to make a profit upwards, downwards and sideways. The Call Ratio Spread and the Put Ratio Spread are the only options trading strategies capable of profiting from all three directions all at once, greatly enhancing the probability of win in a trade. If the spread is entered at a credit the only way a Call Ratio Spread can lose money is when the underlying stock rallies too strongly.
When To Use
A Call Ratio Spread can be used when you are slightly bullish and are confident in a rise in the underlying stock up to a certain price and you want to make money even if the stock should remain stagnant or go downwards instead (if entered at a credit). It is a good options trading strategy for maximising profits on stocks that are expected to hit a technical resistance level and where you are benefiting from the time decay in the sold options.
The Call Ratio Spread strategy is also useful for option traders who wish to speculate on a potential move higher on a stock or index, but may be fearful of a substantial pullback in the near-term. Note that margin will be required in order to hold this position. The Strategy offers limited profit and unlimited risk, when the options trader thinks that the underlying stock will move steadily and experience little upside volatility in the near term.
Call Ratio Strategy Construction
Today we will explain the 1 for 2 Ratio Spread Construction, where you buy 1 ITM Call and sell 2 OTM Calls (to offset the cost of the bought Calls). Buying the Call gives you the right to buy stock at strike price A and selling the two Calls gives you the obligation to sell stock at strike price B if the options are assigned. This strategy enables you to purchase a Call that is at-the-money or slightly out-of-the-money without paying full price. The goal is to obtain the Call with strike A for a credit or a very small debit by selling the two Calls with strike B.
Note: There is unlimited risk in the second Call you sold which is “uncovered”, exposing you to theoretically unlimited risk if the stock goes too high, so you have to monitor any abnormal upside moves in the stock price and have a stop-loss plan in place.
The maximum profit potential of a Call Ratio Spread is attained when the underlying stock closes just below the strike price of the short Call options. At that price, both the written Calls expire worthless, while the long Call expires in the money. Hence the profit potential of a Call Ratio Spread is limited.
1) If the spread is established for a net debit, potential profit is limited to the difference between the short and long strikes, minus the net debit paid.
2) If the spread is established for a net credit, potential profit is limited to the difference between the short and long strikes, plus the net credit.
If the shares fall, the trader can lose no more than the cost of the spread. This protection against a fall in the price of the shares is greater than in the case of a Bull Call Spread due to the higher number of written positions in place.
However, if a strong upward movement occurs unexpectedly the trader faces potentially unlimited losses. The higher the number of unprotected Calls that have been written, the larger the loss that could be incurred.
A Call Ratio Spread will have limited risk to the downside, but has a mixed risk profile on any upward move.
1) If the spread is established for a net debit:
Risk is limited to the debit paid for the spread if the stock price goes down.
Risk is unlimited if the stock price goes way, way up.
2) If the spread is established for a net credit:
Risk is unlimited if the stock price goes way, way up.
Breakeven at Expiry
A Call Ratio Spread will have multiple breakeven levels.
1) If the spread is established for a net debit, there are two break-even points:
Strike A + net debit paid to establish the position.
Strike B + the maximum profit potential.
2) If the spread is established for a net credit, there is only one break-even point:
Strike B plus the maximum profit potential.
In summary the keys to the Risk/Reward of the Call Ratio Option Strategy at expiry are:
* the upside maximum profit is limited
* the maximum loss is unlimited to the upside, but limited to the downside.
Advantages & Disadvantages of the Call Ratio Spread Strategy
The Call Ratio Spread provides good protection for the investor in the event of a market downturn. The price of this protection is the possibility of a loss should the market move further upwards than expected.
Because the strategy involves uncovered written positions, the risk of exercise must be considered and the trader must meet the collateral requirements of the uncovered calls. The risk of early exercise can be avoided by the use of European options which cannot be exercised until expiry.
This strategy benefits from a small upward movement in the market. It should not be used if a strong upward movement is expected. Be wary of constructing the strategy on a ratio higher than 1:2 and be prepared to act quickly if the share price jumps unexpectedly.
The main threat to the Ratio Call Spread comes from a greater than expected surge in the stock price. If this occurs, the trader may consider closing out the spread, or alternatively closing out the sold options to reduce the risk of exercise.
If the share price falls dramatically, the trader may adjust the position. This could be done by buying back the long Call before it loses too much time value, however the danger in closing out the long position is that a market reversal leaves the trader totally exposed on the short legs. Alternatively leg out of the short Calls in anticipation of a bounce. Note that either of these actions redefines the goals of the initial trade.
Recent Trade – Newcrest Mining (NCM)
With this outlook in mind Newcrest Mining (NCM) has recently provided some excellent opportunities for Call Ratio Spreads. Newcrest has been trading in a downtrend for the past ten months and appears to be trying to establish support above the $9.50 level.
However Australia’s largest listed gold miner Newcrest Mining is on record that it is anticipating writedowns against its assets, with total impairment charges of up to $6.2 billion, when it announces its full-year results for the 12 months to June 30 next week.
Buying Newcrest stock outright is akin to trying to catch a falling knife. This is where the Call Ratio Spread Strategy comes into its own.
Here is a recent Call Ratio Spread trade on NCM, taken with the view that Newcrest may find support above its $11.00 pivot level (for the past two months) and that the price will be contained below the recent resistance of $13.00.
We were expecting to see resistance around the $13.00 level for NCM, so we are looking to accumulate NCM here above $11.25. The position would be stopped out if the NCM stock surged above the recent $13.00 resistance level.
Newcrest Mining (NCM) Chart
CHART 1: Newcrest Mining (NCM) (yellow area denotes profit region for Call Ratio Spread)
The trade was entered when NCM was trading around $11.35. The trade was established by Buying to Open NCM 1125 AUG13 Call for 59.5 (NCMVP7) and simultaneously Selling to Open twice as many of the NCM 1225 AUG13 Calls for 22.5c (NCMNT7). The total debit was the 14.5 cents premium per contract, or $1450 for 100 contracts.
Payoff Diagram at August Expiry
CHART 2: Payoff Diagram at Expiry for Newcrest Mining (NCM) Call Ratio Spread
Trade Risks and Profit Potential
The risks and rewards are shown in the Payoff diagram above. This Call Ratio Spread position offers limited losses if the stock price continues to fall and a mixed profit profile if the stock price rises above the short Call strike price, with unlimited exposure to the additional short Calls that are not covered by the long Call position.
Note the Call Ratio Spread position can be used in order to gain leveraged exposure to Newcrest Mining (NCM), while limiting the losses in the event of a substantial pullback and with mixed profit if the share price bounces from here.
The trade is still in progress and will no doubt fluctuate with the earnings results that are to be delivered next week. Today with NCM trading at $11.60 the trade could be closed out for 33c/contract (more than doubling your money).
Options can be used in order to gain leveraged exposure with limited outlay and/or risk, while still participating in potential profits from various movements in the underlying stock.
Today we’ve explained the Call Ratio strategy, which is a vertical ratio spread with the ability to make a profit in all three directions: upwards, downwards and sideways. It is a limited profit, unlimited risk options trading strategy that is taken when the options trader thinks that the underlying stock will experience little volatility in the near term. Ideally this strategy needs the underlying stock to remain below the short strike for maximum profit potential.
Note the Call Ratio Spread can also be used to repair a long stock position that has been hit with an unrealised loss. This stock repair strategy, which we have discussed previously, can reduce the price needed to break even on the long stock with virtually no cost.
The market had a great run in July. There is another trade setting up right now, that you could potentially profit from. If you would like more information please contact me at call 1300 610 024 or email email@example.com.
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Also In This Series
Part 1: The Protective Put
Part 2: The Covered Call
Part 3: The Covered Call Collar
Part 4: The Stock Repair Strategy
Part 5: Limited Risk Short Selling Strategy
Part 7: Dividend Capture Covered Call Collar
Part 8: Hedging With a Bear Put Spread
Part 9: The Bull Call Strategy
Part 10: Dividend Capture Covered Call Collar
Part 11: Calendar Call Strategy
Part 12: Bull Call Spread Strategy
Part 13: Reverse Calendar Call Strategy
Part 14: Short Selling Strategy with a Hedge
Part 15: Alternate Profit Taking Strategy
Part 16: Bullish on the Cheap
Part 17: Trade Smarter with Options
Part 18: Trade The Switch with Options
Part 19: Managing The Protected Capped Covered Call Collar Trade
Part 20: The Synthetic Long Stock Strategy
Part 21: Dividend Protection Strategy
This report was prepared by Michael Hevern. It represents the views and opinions of the author. It is not intended for use by any third party, without the approval of Michael Hevern. While this report is based on information from sources which are considered reliable, its accuracy and completeness cannot be guaranteed. Any opinions expressed reflect my judgment at this date and are subject to change. Contracting Hevern Pty Ltd is a Corporate Authorised Representative No. 408868 of D2MX Pty Limited ABN 98 113 959 596, AFSL No. 297950 (D2MX), and Michael Hevern has been appointed as an Authorised Representative of Contracting Hevern Pty Ltd. Opinions, conclusions and other information expressed in this report are not given or endorsed by D2MX, unless otherwise indicated. The information contained in this Report is General Advice only, as the information or advice given does not take into account your particular objectives, financial situation or needs.
Disclaimer: Using leverage to invest can be a two edged sword, as it can magnify your returns when the stock price rises, but will in turn magnify the losses if the trade does not perform as expected.