Derivatives

How to set up a bull-ratio spread

Venkatesh Bangaruswamy | Updated on February 13, 2021

The advantage is low cost, which increases your profit potential

In a bull-call spread, you buy a lower strike call and short a higher strike call. But what if you decide to short more number of higher strike calls? Such a strategy is called bull-ratio spread. In this article, we discuss when to set up such a spread and the characteristics of and risks associated with this strategy.

Ratio spread

Think of a bull-ratio spread as a bull-call spread plus a short call. Suppose you set up bull-call spread by going long on 15,100 call and short on 15,300 call. A ratio spread can be set up by going long one contract of 15,100 call and short two contracts of 15,300 call.

Note that one contract of 15,300 short call is covered by one contract of 15,100 long call. Therefore, you have a naked short position on the other 15,300 call. This exposes the ratio spread to high risk. And this risk will materialise into large losses if the stock trades above 15,300; for the 15,300 call will become in-the-money and carry intrinsic value causing large losses from the naked short position.

Because the maximum profit you can generate from a short position is the option premium, you want the short call to expire worthless. This means the maximum profit on the ratio spread will occur when the stock trades at 15,300 at option expiry. The maximum profit will be the difference between the strikes minus the net debit (the cost of setting up the spread).

Sometimes, depending on the distance between the strikes, the ratio spread can be set up for a net credit. Then, your maximum profit is the difference between the strikes plus the net credit. What if the stock declines and even 15,100 call expires worthless? Then, your loss is equal to the net debit, or you keep the initial premium if you set up the position for a net credit.

You can set up a bull-ratio spread when two conditions are met. One, you believe that the current implied volatility is very high. And two, the underlying faces a strong resistance not far from the current level. That is, despite your bullish outlook, you believe that the underlying is unlikely to move significantly from the current level.

As in the case of a bull-call spread, your short option should be one strike above the resistance level. This gives you room for error in the event the stock breaks above the resistance level, even if temporarily. The advantage of a bull-ratio spread is the low cost-- because you short more calls than you buy-- thereby increasing your profit potential.

Optional reading

A bull-ratio spread has positive delta whereas typical ratio vertical spreads are delta-neutral. Suppose you go long on an ATM call with a delta of 0.51 and short two OTM calls, each with delta of 0.20. You spread will have net positive delta 0.11. This spread has negative vega and, therefore, benefits from declining volatility.

The position incurs large losses if underlying moves up sharply, for the spread will then invert from positive delta to negative delta. The spread benefits from passage of time because of positive theta which means it has negative gamma (as gamma and theta are trade-offs). Also, note that margin requirement will be higher compared to a bull-call spread because you have a naked short position.

Your first break-even is lower strike call plus the net debit. The second break-even is the higher strike call plus the difference between the strikes less the net debit.

A word of caution: Given the high risk associated with bull-ratio spread, it is better to set up a bull-call spread if you have just started trading options . Or as discussed last week, you can roll into a bull call spread if you want to reduce the net debit.

The writer offers training programme for individuals to manage their personal investments. Looking to understand derivatives better?

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Published on February 13, 2021
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