How you should convert call spread into ratio spread

Last week, we discussed how to reduce losses on a long call by converting the position to a bull call spread. But what if your initial position is a bull call spread? This week, we look at how converting a call spread to a ratio spread or to a lower strike call spread can help you reduce losses, if not generate profits, on your initial position.

Conversion ratio spread

Suppose you expect an underlying to find resistance at 14760. You set up a bull call spread by going long on a 14700 call and shorting the 14800 call on the same underlying for the same maturity. With the underlying currently trading at 14653, the spread can be set up for a net debit of 51 points (166 less 115).

Now, suppose the underlying declines to 14580 two days after your set up the spread, which is scheduled to expire on May 6. Then, the 14700 call could decline to 133 and the 14800 call to 97. So, your spread would lose 15 points (51 less 36). How can you recover this loss? As with the conversion spread that we discussed last week, the following strategy is based on the premise that you expect the underlying to bounce back from the current level.

Suppose you believe the underlying will move from 14580 to 14640. Here is how you can set up a conversion strategy: First, buy 14600 call. Note that this strike is the immediate in-the-money strike. Next, sell two contracts of the 14700 call. The conversion can be set up for a net credit of 88 points (266 less 178).

You have converted your 14700/14800 call spread into a ratio spread. Typical ratio spread will be of 1:2 ratio- long one contract of lower strike call and short two contracts of a higher strike call. In this case, however, you are long one contract of the 14600 call, short one contract of the 14700 call and one contract of 14800 call, which is short call from the initial call spread.

The ratio spread exposes you to risk if the underlying moves past 14800 because you have a naked short position on the 14800 call. Any loss on the 14700 call can be offset from gains on the 14600 call. So, the conversion from call spread to a ratio spread will be profitable only if you expect the underlying stay below 14800.

The maximum profit on the ratio spread will be difference between the first two strikes (14600 and the 14700) less the conversion credit plus the initial net debit. So, the maximum profit will be 137 points (100 less 88 plus 51) and occurs if the underlying trades between 14700 and 14800 at option expiry. The break-even for this spread is lower strike (14600) less conversion credit (88 points) plus net debit (51 points), which is 14563. In contrast, the break-even for the initial call spread was 14751 (14000 plus 51). The conversion to a ratio spread significantly reduces the break-even and improves your chance of making profits.

Optional reading

If you are uncomfortable keeping a naked short position on the upper strike call, you can convert your initial 14700/14800 call spread to a 14600/14700 spread. But you have to buy the 14800 call at 97 points to close your short position. So, your break-even now will be 14660, which is the lower strike less conversion credit plus initial net debit plus the cost of buying the upper strike call. So, converting to a lower strike spread will be optimal only if you expect the underlying to move past 14660. Otherwise, the ratio call spread will be better.

The above discussion shows that you have three alternatives to choose from: Convert to a ratio spread or convert to a lower strike spread or close the initial call spread position and take losses.

The author offers training programmes for individuals to manage their personal investments

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