Understanding The Net Credit Call Ratio Back Spread Strategy

In this issue, we revisit the Call Ratio Back Spread strategy, focusing on its net credit variant. Unlike the net debit version, this approach enables traders to initiate the position with a credit, allowing for potential profits even if the underlying asset remains stable. Let’s explore how trader Sarvani Shah uses the Net Credit Call Ratio Back Spread to navigate her current market outlook

The Net Credit Call Ratio Back Spread is an advanced options strategy designed for bullish market scenarios with high volatility expectations. It involves selling one in-the-money (ITM) call option and buying two out-of-the-money (OTM) call options, resulting in net credit. This setup ensures that traders can retain the initial credit as profit if the underlying price remains below the breakeven point.

The net credit variant of the Call Ratio Back Spread is particularly beneficial for traders who:
• Anticipate High Volatility: Profit from significant upward market movements while minimising downside risks.
• Seek an Advantageous Entry: Begin the trade with a net credit, allowing profits even if the market remains stable.
• Limit Losses: Risk is capped on the downside, ensuring controlled exposure.

For Sarvani, this strategy is ideal given her expectation of a potentially bullish but uncertain market. Executing the Net Credit Call Ratio Back Spread Here’s how Sarvani sets up her position:
1. Nifty Current Market Price: ₹23,750
2. Sell 1 Lot ITM Strike 23,600 CE Price: ₹620
3. Buy 2 Lots OTM Strike 24,200 CE Price: ₹295 each
4. Expiry Date: January 30, 2024.

Sarvani sells one ITM call option at ₹620 and buys two OTM call options at ₹295 each. This results in a net credit of ₹30 (₹620 - ₹590).

Breakeven Points
The Call Ratio Back Spread has two breakeven points:
• Lower Breakeven Point: Strike Price of Sold Call = 23,600.
• Upper Breakeven Point: Strike Price of Bought Call + Difference in Strike Prices – Net Credit = 24,200 + 600 – 30 = ₹24,770.

Sarvani’s profit potential begins if Nifty closes above ₹24,770 at expiry, with limited profit below ₹23,600.

Payoff Structure
The payoff for the Net Credit Call Ratio Back Spread depends on Nifty’s closing price at expiry:
1. If Nifty remains below ₹23,600 (Lower BEP):
• All options expire worthless, and Sarvani keeps the net credit as profit.
• Maximum Profit: ₹30.

2. If Nifty is between ₹23,600 and ₹24,770:
• The sold ITM call incurs losses, while the bought OTM calls provide partial offset.
• Sarvani incurs a manageable loss depending on the exact price.

3. If Nifty rises above ₹24,770 (Upper BEP):
• The bought OTM calls gain significant value, while the loss on the sold ITM call is capped.
• Maximum Profit: Unlimited as Nifty continues to rise.

The table shows Sarvani’s maximum profit of ₹30 below ₹23,600 and unlimited profit above ₹24,770. Her maximum loss occurs between the breakeven points.

Net Credit vs Net Debit Variant
Both the Net Credit and Net Debit Call Ratio Back Spreads are designed for bullish markets, but they differ significantly:

1. Initial Position:
• Net Credit: Begins with a credit, offering a profit if the market remains stable or moves slightly downward.
• Net Debit: Requires a small upfront payment, making it less profitable in a stagnant market.

2. Risk and Reward:
• Net Credit: Limited profits and higher breakeven points due to the credit received.
• Net Debit: Lower breakeven points but requires the market to move significantly upward to profit.

3. Market Outlook:
• Net Credit: Suitable for moderately bullish markets with high volatility.
• Net Debit: Ideal for strongly bullish markets.

Conclusion
The Net Credit Call Ratio Back Spread provides traders like Sarvani with a flexible, cost-effective way to profit from bullish market scenarios. By starting the trade with a net credit, this variant ensures that traders can benefit even if the market doesn’t move significantly upward. However, this strategy requires careful monitoring, especially in low-volatility environments where the market may fail to breach the upper breakeven point. Additionally, while this strategy works well for stocks with high directional potential, traders must ensure sufficient liquidity in the options to avoid suboptimal execution.

An important consideration in the Call Ratio Back Spread strategy is the gap between the ITM and OTM strikes. This gap defines whether the strategy operates on a net credit or net debit basis. A wider gap increases the breakeven points, which, while offering larger potential profits, also reduces the probability of winning. Traders must carefully select strike prices to balance risk, reward, and the likelihood of success. As Sarvani continues her trading journey, she appreciates the adaptability of the Call Ratio Back Spread strategy and its ability to align with varying market conditions. With each trade, she grows more confident, leveraging her knowledge to navigate both opportunities and risks effectively.