Understanding The Call Ratio Spread Strategy – Net Credit

In this issue, we delve into the Call Ratio Spread strategy, focusing on the Net Credit variant where more options are sold than purchased. This approach allows traders to benefit from a bearish, range-bound or slightly bullish market with limited profit potential but unlimited risk. Let’s explore how Sarvani Shah applies the Call Ratio Spread (Sell More) to her current market view

What is a Call Ratio Spread (Net Credit)?
The Call Ratio Spread (Net Credit) is a neutral to bearish options strategy. It involves buying one in-the-money (ITM) call option and selling two out-of-the-money (OTM) call options. This creates a credit at the outset, offering traders an upfront profit and exposure to unlimited risk beyond the breakeven point. The strategy is most effective in a market expected to trade bearish, within or slightly above a specific range.

Why Call Ratio Spread (Net Credit)?
This strategy suits traders who:
• Anticipate Limited Upside or Bearishness: Profitable when the underlying asset remains below a specific level or rises slightly.
• Prefer a Cost-Effective Setup: The initial credit provides a cushion against losses.
• Understand the Risk: While the strategy generates limited profit, the risk above the upper breakeven point is unlimited.

Sarvani found the Call Ratio Spread (Net Credit) appealing as it aligned with her expectations of a negatively range-bound or slightly bullish Nifty in the coming weeks.

Executing the Call Ratio Spread (Net Credit)
Here’s how Sarvani set up her position:
• Nifty Current Market Price: ₹23,700
• Buy 1 Lot ITM Strike 23,600 CE Price: ₹480
• Sell 2 Lots OTM Strike 23,800 CE Price: ₹365 each
• Expiry Date: January 30, 2024

Sarvani buys one ITM call at ₹480 and sells two OTM calls at ₹365 each, resulting in a net credit of ₹250 (₹730 received - ₹480 paid).

Breakeven Points
The Call Ratio Spread (Net Credit) has one critical breakeven point:
1. Upper Breakeven Point:Strike Price of Sold Call + Strike Price Difference + Net Credit
2. Calculation: 23,800 + 200 + 250 = ₹24,250 Sarvani’s profit potential lies below ₹24,250. Any price movement above this level leads to unlimited losses.

Payoff Structure
The payoff for the Call Ratio Spread (Net Credit) depends on Nifty’s closing price at expiry

1. If Nifty remains below ₹23,600 (ITM Strike):
• Both sold OTM calls and the bought ITM call expire worthless.
• Sarvani keeps the net credit as profit.
• Maximum Profit: ₹250.

2. If Nifty is between ₹23,600 and ₹24,250:
• The sold OTM calls incur losses, but the bought ITM call offsets them.
• Net Payoff = Profit/Loss from Bought and Sold Calls + Net Credit.

3. If Nifty rises above ₹24,250 (Upper Breakeven):
n The sold calls’ losses exceed the gains from the bought call, resulting in unlimited risk.

This table shows Sarvani’s maximum profit of ₹450 will be at 23,800 level while Minimum profit ₹250 is below 23,600 level, and her risk becomes unlimited above 24,250 level.

Call Ratio Spread (Net Credit) vs. Call Ratio Back Spread (Net Credit)
Although both strategies involve selling more options than buying, their market outlooks and structures differ:

1. Market Outlook:
• Call Ratio Spread (Net Credit): Suitable for bearish, range-bound, or slightly bullish markets.
• Call Ratio Back Spread (Net Credit): Designed for bullish markets with significant upward potential.

2. Profit Zone:
• Call Ratio Spread: Profits from limited upward movement, sideways, or bearish markets.
• Call Ratio Back Spread: Profits from sharp upward movement due to additional bought options.

3. Risk Structure:
• Call Ratio Spread: Limited profit potential with unlimited risk above the breakeven point.
• Call Ratio Back Spread: Unlimited profit above the upper breakeven, with limited loss below it.

Conclusion
The Call Ratio Spread (Net Credit) offers traders like Sarvani a versatile way to profit in range-bound or slightly bullish markets. By receiving a net credit upfront, the strategy provides a cushion against potential losses and enhances profitability in stable conditions.

However, traders must carefully monitor the position, as the strategy’s effectiveness diminishes in highly volatile markets. Additionally, selecting appropriate strike prices is critical, as the gap between ITM and OTM strikes determines the breakeven points and the balance between risk and reward.

This strategy is particularly effective on indices, as they tend to move within smaller ranges compared to individual stocks. The controlled movement of indices makes the Call Ratio Spread (Net Credit) a reliable tool for generating consistent returns. However, traders should remain cautious applying this strategy to stocks, as their higher volatility and larger price swings can increase the risk of significant losses. As Sarvani refines her trading techniques, she continues to build a robust understanding of how different strategies fit varying market conditions, strengthening her position in the complex world of options trading.