Ratio Call Spread

What Is a Ratio Call Spread

Ratio Call Spread:

Buy 1 call with lower strike price
Sell 2 or more calls with higher strike price

All contracts should have the same expiration month. The ratio call spread is similar to a long call spread, but with one or more extra short calls. These extra calls can increase potential profit, but are uncovered. As the stock price increases you're exposed to increased risk on the upside. Depending on the expiration month you choose, and whether the strike prices are in-, at-, or out-of-the-money, this spread may be put on for either a net debit or a net credit for the transaction.

Why Use a Ratio Call Spread

Investors use ration call spreads when they expect a steady underlying stock price over a certain period of time, and want to speculate about where it will be at expiration (at the short calls' strike price.) They want to profit from the short contracts' time decay, but still want to limit their overall short call risk with a long call position.

Market Opinion of Ration Call Spreads

This is considered a neutral strategy.

You don't want the stock price to move much in either direction while you have this position on.

Maximum profit potential: limited

You should see maximum profit if the underlying stock closes exactly at the short calls' strike price at expiration. If this happens, your short contracts will expire at-the-money and worthless. The long one will be in-the-money and have intrinsic value.

Loss potential: upside unlimited; downside limited to net debit paid for the spread

As the underlying stock price rises above the short calls' strike price, your uncovered short contract(s) expose you to an unlimited loss potential. If the stock closes below both strike prices at expiration, all contracts will expire out-of-the-money and worthless and your loss is limited to the net debit paid for the spread. Under the same circumstances, if you established the spread for a net credit you keep it and the position makes a small profit.

Break-even point (B.E.P.) at expiration:

Upside B.E.P. = underlying stock price = short strike + (maximum profit ÷ number of naked calls)
If debit paid for the spread: downside B.E.P. = underlying stock price = long strike price + debit paid

Possible Scenarios of Using Ratio Call Spreads

Positive Scenario of Ratio Call Spreads

At expiration, the underlying stock closes exactly at the short calls' strike price. In this case your long call will have intrinsic value, the short calls will expire at-the-money and worthless, and you make your maximum profit.

Negative Scenario of Ratio Call Spreads

The stock price goes up significantly and the value of your uncovered short call(s) increases.

How does Volatility impact Ratio Call Spreads?

An increase in implied volatility is generally a negative factor for this spread; a decrease is generally a positive one. Remember, you are short more calls than you are long.

Time Decay and Ratio call Spreads

The effect of time decay varies. When the stock is at the short calls' strike price the effect can often be positive – when at the long call's strike price the effect can be negative.

Example Ratio Call Spread Trade:

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Please note: All or part of your investments using neutral strategies has greater risk of loss in volatile markets.