Call Ratio Backspread: Meaning, Example, and How to Devise an Effective Strategy

Options trading involves a nuanced understanding of markets and various trading strategies. One among them is call ratio backspread. A call ratio backspread strategy is designed to help you benefit from a significant rise in the stock price in the near term. Let’s dig deep to understand better the various aspects of a call ratio backspread strategy.

What Is The Call Ratio Backspread?

Call ratio backspread is a popular options trading strategy involving buying and selling call options in a specific ratio to benefit from bullish market scenarios. Combining long and short call options, it allows you to benefit from upward price movement and limited downside risk. In this strategy, you typically buy more call options than you sell.

When you do this, you create an unbalanced ratio. This results in creating a net long position. This long position can benefit you if the underlying asset's price increases and limit potential losses if prices don't move as expected.

Components Of The Call Ratio Backspread Strategy

The components of this strategy include:

• Ratio: The strategy involves a certain ratio, generally 2:1. It means you buy two call options for every option sold.

• Strike selection: You can select an out-of-the-money call option for long positions and an in-the-money call option for short positions.

• Expiration date: The call options in this strategy should have the same expiration date, providing ample time for the position to work in your favour.

• Bullish outlook: Deployment of this strategy should be in a bullish market when you expect a significant increase in prices of underlying securities.

Call Ratio Backspread Example

Let’s understand this strategy better with an example. Suppose you believe that XYZ stock trading currently at ₹ 100 is poised to increase further. You implement a call ratio backspread to cash in on the bullish outlook. You select the following strike prices:

• Buying 2 call options at a strike price of ₹ 95
• Selling 1 call option at a strike price of ₹ 105

Let's examine the potential outcomes based on two different market scenarios:

1. Bullish: If the stock prices rise significantly, suppose at ₹ 120, you tend to make profits. This is because the two long call options at a lower strike price of ₹ 95 will gain value. On the other hand, the short call option at the higher strike price of ₹ 105 will become worthless and expire.

2. Bearish: Suppose XYZ's stock price decreases to ₹ 90, there are chances of facing limited losses as both long call option and short sell option will lose their value. That said, losses on long call options will be partially offset by the premiums from selling short call options.

Devising An Effective Call Ratio Backspread Option Strategy

Here’s how you can devise an effective call ratio backspread option strategy:

• Zero in on the right market conditions

Call ratio backspread is at its best in bullish market conditions or when stock prices are expected to rise sharply. Hence, it’s vital to choose the right market conditions. Use technical analysis and indicators to gauge market sentiment before deploying it.

• Choose the appropriate strike prices

Opting for the right strike prices can help maximise the strategy’s effectiveness. Make sure the strike price is in sync with markets.

• Select the right expiry date

Pick an expiry date that allows you sufficient time for the price to move as you expect. If you choose an expiration date that is too short, there might not be enough time for the stock to make the move you anticipate.

• Monitor your position

Closely monitor your position and exit early if markets don’t move as expected.

Wrapping it up

While the call ratio backspread strategy can help you in bullish markets, executing it can be complex. At the same time, it warrants high trading experience before you can execute it. Make sure to grasp the nuances well before going ahead with it.

Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.

Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.