One of my favorite limited risk with unlimited reward strategies is the call ratio backspread. A call ratio backspread is a delta-neutral (non-directional risk trade), which allows us to profit substantially from strong upward movement; however, we hedge and protect ourselves from downward movement.
Because of the downside hedge, if we are incorrect, and the stock goes against us, we are in a position where we won’t lose anything; or we may even realize a small profit, depending on how we enter into the trade. We would use a call ratio backspread when we have a bullish bias and expect the stock to make a significant move. If we are correct and the stock makes a strong move to the upside, we will be in a position which has unlimited profit potential. If we are wrong and the stock moves against us, we can let the options expire worthless, not have to pay commissions to exit, and not lose money.
Placing call ratio backspreads on strong, uptrending stocks will further increase your chances of success. As compared with stock, they can offer the same unlimited reward potential but also provide you with limited downside risk. Compared with just buying calls, they can offer the same unlimited reward potential with a lower breakeven and less cost. Also, this trade helps to counter some of the impact from volatility in the markets, which allows us to place the trade after news has already come out on a particular stock.
A call ratio backspread strategy is structured by selling a certain number of calls at a lower strike and at the same time buying more calls, at a higher strike. This position is created in a ratio such that you sell fewer calls than you buy in a ratio of .67 or less. For instance, a 1 x 2 consists of 1 short call and 2 long calls. Similarly, you can create a 2 x 3, 3 x 5, or any combination trade with a ratio less than .67.
Call ratio backspreads are best placed in markets with a reverse volatility skew. In these markets, the lower strike options (the ones you want to sell) have higher implied volatility and can be overpriced. The higher strike options (the ones you want to buy) enjoy lower implied volatility and are often underpriced. By trading the reverse volatility skew, you can capture the implied volatility differential between the short and long options.
We want to make sure we give ourselves enough time to be right in this trade. The more time we can buy the better. With diligent research we can pinpoint good call ratio backspread trades with longer time frames and many times can even use LEAPS. Also, if we can’t get in for even or for a small credit, we will want to find a different stock or use a different strategy.
Although we can get into this trade for a small credit, there is still a window of risk. The maximum risk occurs when the stock is at the strike we are long on expiration date. The broker will require and hold the risk amount as collateral in our account through the duration of the trade to protect from the worst-case scenario at expiration.
Taking into account the call ratio backspread advantages, which are unlimited upside profit potential, can be done at a credit. We can control the risk by how long we stay in the trade, and having a much lower risk than a long call directional trade makes this a truly dynamite strategy to implement for potentially explosive stocks.
Staff Writer & Options Strategist
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