Understanding The Call Ratio Back Spread Strategy

In the realm of options trading, the Call Ratio Back Spread strategy emerges as a powerful tool for traders with a bullish outlook and expectations of high volatility. This strategy leverages an imbalance in the number of call options sold and purchased, allowing traders to benefit from strong upward market movements while minimising risk. Let’s dive into how our fictional investor Sarvani Shah uses the Call Ratio Back Spread to capitalise on a potentially explosive bullish scenario.

The Call Ratio Back Spread strategy involves selling a lower number of call options at an at-the-money (ATM) strike price and buying a higher number of call options at an out-of-the-money (OTM) strike price. This setup creates a ratio (for example, 1:2) where the trader pays a net debit or receives a net credit depending on the premiums involved. The strategy is most profitable when the underlying asset experiences a significant upward move.

Why Call Ratio Back Spread?
The Call Ratio Back Spread is ideal for traders who:
1. Anticipate Strong Bullish Moves: The strategy benefits from sharp upward movements, as the long OTM calls multiply in value.
2. Minimise Risk: The limited loss on the downside (capped at the net premium paid or net credit received) makes it a safer alternative to buying naked calls.
3. Benefit from Volatility: The strategy thrives in highvolatility environments where rapid price changes amplify potential gains.

For Sarvani, the Call Ratio Back Spread aligns with her market view, which anticipates high volatility and a strong bullish move in Nifty.

Executing the Call Ratio Back
Spread Let’s examine Sarvani’s setup for the Call Ratio Back Spread strategy:
• Nifty Current Market Price: ₹24,700
• Sell 1 Lot ATM Strike 24,700 CE Price: ₹310
• Buy 2 Lots OTM Strike 25,000 CE Price: ₹170
• Expiry Date: December 26, 2024.

Sarvani sells one lot of 24,700 CE for ₹310 and buys two lots of 25,000 CE for ₹170 each. This results in a net debit of ₹30 (₹340 paid for two lots minus ₹310 received for one lot).

Breakeven Points
The Call Ratio Back Spread has two breakeven points:
1. Lower Breakeven Point: Strike Price of Sold Call – Net Debit = 24,700 – 30 = ₹24,670.
2. Upper Breakeven Point: Strike Price of Bought Call + Spread Range + Net Debit = 25,000 + 300 + 30 = ₹25,330.
Sarvani’s profit potential begins if Nifty closes above ₹25,330 at expiry.

Payoff Structure
The payoff for the Call Ratio Back Spread depends on Nifty’s closing price at expiry. Here’s how it works:

1. If Nifty remains below ₹24,670 (Lower BEP):
• Both call options expire worthless, and Sarvani incurs a loss equal to the net debit.
• Maximum loss = ₹30.

2. If Nifty is between ₹24,670 and ₹25,330:
• The sold ATM call incurs a loss, while the bought OTM calls gain value. Sarvani’s position might result in a small profit or loss depending on the exact price.

3. If Nifty rises above ₹25,330 (Upper BEP):
• The bought OTM calls gain significant value, while the loss on the sold ATM call is limited.
• Maximum profit is unlimited as Nifty continues to rise.

The table above shows that Sarvani’s maximum loss of ₹30 occurs when Nifty stays below ₹24,670. As Nifty rises past ₹25,330, her gains accelerate due to the two OTM calls.

Call Ratio Back Spread vs Long Call
While the Call Ratio Back Spread and Long Call strategies both benefit from bullish market moves, they differ significantly:

1. Cost Efficiency:
• Call Ratio Back Spread: Involves selling one call to offset the cost of buying two calls, reducing the net debit.
• Long Call: Requires paying the full premium upfront, resulting in higher initial costs.

2. Risk and Reward:
• Call Ratio Back Spread: Limited risk on the downside, with unlimited profit potential above the upper breakeven.
• Long Call: Limited risk (premium paid) but requires a significant upward move for profitability

3. Profit Zone:
• Call Ratio Back Spread: Profitable over a wider range of price movements due to the offsetting premium structure.
• Long Call: Profitable only if the underlying asset rises significantly above the strike price.

Conclusion
The Call Ratio Back Spread strategy offers traders an opportunity to benefit from sharp upward movements while keeping the downside risks limited. With its unique structure, the strategy aligns well with Sarvani’s bullish market outlook and preference for cost-efficient trading. By mastering this approach, Sarvani continues to expand her trading expertise, learning to balance risk and reward in increasingly complex market scenarios.

However, this strategy may not work as effectively on indices, which tend to be less volatile and move within smaller ranges compared to individual stocks. For stocks, the Call Ratio Back Spread can be particularly effective, provided the trader ensures sufficient liquidity before taking entry. Low liquidity in stock options can lead to suboptimal pricing and execution challenges. Therefore, trader needs to first be clear about whether he or she wants to trade as per indices or stocks before using this strategy.