A bull call ratio backspread strategy is among the most popular option trading strategies that offer unlimited profit potential. It is a bullish, risk-defined, and multi-leg strategy. As it is a bullish strategy, traders with a bullish outlook on the underlying security use this strategy.
So, what is this bull call ratio backspread strategy? That’s what we are going to explain in this detailed guide. In this article, we shall discuss what this bull call backspread strategy, how it works, and some other aspects. Let’s begin right away.
Bull call ratio backspread strategy definition
A bull call ratio backspread strategy is a bullish option spreading strategy. It involves selling at-the-money or out-of-the-money call options or options first and then buying call options with the same expiration date but a different strike price. The ratio between long and short calls is generally 2:1, 3:1, or 3:2. This options strategy seeks to gain from a bullish trend in the market while limiting potential losses if the market trend reverses.
Option traders use a bull call ratio backspread strategy during bullish trends in the market. It is important to note that the market sentiment should be extremely bullish. In a low or moderate bullish market, the strategy doesn’t work. Traders only go for this strategy if they believe that the price of the underlying security will dramatically rise. As the strategy involves both long and short calls, the profit potential is significantly high if the price rises. It is because of the higher long call options ratio.
Furthermore, traders also keep a particular ratio in mind. As this is a three-legged strategy, you need to buy two call options against one call option you sell. Similarly, if you sell two options, you need to buy four call options. Additionally, it is also important that you buy and sell options of the same underlying security and the same expiration date.
Profit potential and risk
As traders hold more long call options than short call options, a bull call ratio backspread strategy offers unlimited profit potential. Unlimited in the sense that no one knows how much the price of the underlying security will rise. Interestingly, this is just one side of the coin. Traders, who are good at trading, can make a profit when the price decreases. This is a very interesting feature of this strategy.
On the flip side, traders face significant losses if the strike price of the underlying security increases at the time of the expiration date. How much loss do they incur in such situations? They calculate it by subtracting net credit received from the price difference between options bought and sold. This is the highest loss if things don’t go as planned.
Example to understand a bull call ratio backspread strategy
Let’s try to understand a bull call ratio backspread strategy with the help of an example. Let’s suppose that you are bullish on the stock of a company named ABC. You strongly believe that the price of the stock will dramatically increase in the near future. Let’s suppose that the current strike price is $20 per share. Whereas call at-the-money options with a strike price of $20 accompany a premium of $2 each. And call options for a strike price of, say, $16 are available at $6 each. Now, how will you execute this strategy? Let’s see it step-by-step.
- Firstly, you need to buy 2 options contracts and each contract contains 100 options and costs $400.
- Secondly, you need to sell one call option at a strike price of $16. So, you will get a credit of $600 into your account. And your net credit is $200 now as you received $600 and paid $400 for buying 2 options contracts.
- Now, if the strike price increases to $22 by the expiration date, you will earn $2 on the two call options you purchased in the first step. However, you will incur a loss of $6 on the call options you sold. How so? Because you will have to sell stocks at $16 while the market price will be $22. Thus, your total loss will be $600.
- Finally, how much will you earn or lose? You will calculate it by subtracting the $400 you will earn plus your net credit from the $600 loss. In this example, you will be at breakeven.
So, it is crystal clear from the above example that the price of the underlying security has to rise significantly for you to make money. Now, what if the price moves to $28 per share? You will make gains of $1600 on two call options while making a loss of $1200 ($12 × 100). Therefore your net gains will be $600 ($1600 + $200 – $1200).
Pros and cons of a bull call ratio backspread strategy
The following are the main advantages of the bull call ratio backspread strategy.
- One of the easiest to implement and execute option trading strategies.
- Enables you to capitalize on the dramatic increase in the price of the underlying security.
- Carries less risk as it also covers when the price falls instead of rising.
- Promises higher profit potential as there is no limit to how much the price of the underlying security can rise.
On the flip side, the following disadvantages can affect your trading.
- Only applicable in a highly bullish market
- A higher increase in the price of the underlying security is necessary.
- Expensive strategy as compared to other option trading strategies