Construction
In order to construct a call ratio spread we must buy a certain quantity of ITM calls (they can also be ATM or OTM) and write more OTM calls, with the same expiration date on the same underline security. The spread should produce a net credit (the money received from the short calls should be more than the money paid for the long calls).
If for example we buy 1 ITM call and write 2 OTM calls with higher strike then we have a ratio of 1:2. It is an extension of the call bull spread strategy but with more OTM than ITM calls.
When to use
When we believe that the price of the underline security will rise but not above the OTM strikes of the short calls, without simultaneously lose our potential to profit from a downward movement of the price or no movement at all. So by applying a call ratio spread we can be profitable irrelevantly of direction as long as the price of the underline at expiration is not far beyond the strike of the OTM calls (above the break-even point).
Suppose that we are long 1 ITM call with strike $25 and premium $1 and short 2 OTM calls with strike $27 and premium $0.75. The net premium received for the opening of the position is $50 [($0.75×200)-($1×100)].
If the stock price at expiration is below the lower strike i.e. $23, all the calls are worthless and we have a profit equal to the net premium received ($50), without estimating commissions.
If the stock price at expiration is within the two strikes ($25 and $27), then again we are profitable. In that case our profit will be different depending on where the price of the underline will be at expiration. If it is exactly at the lower strike ($25) then we achieve a profit equal to the net premium received ($50) because all options are expiring worthless. If it is at the higher strike ($27) then the 2 short calls are expiring worthless and we can exercise the long call. The profit in this case is equal to $250 {[($27-$25)x100]+$50}, which is the maximum possible. Any price in between the two strikes produces profits from $50 to $250.
If the stock at expiration is far above the higher strike, then we have a loss. The profit from the long call will counter-weight the loss from one short call but the second will remain without match and it can produce unlimited losses as long as the stock keeps on rising. In that sense, the higher the ratio, the more risky the strategy becomes, because a higher number of short calls will not be counter-weighted from long calls, hence the loss can be greater.
Loss/Profit at expiration
Maximum loss: Unlimited to the upside – net premium received + commissions.
Maximum profit: (Higher strike – Lower strike) + net premium received – commissions.
Profit/Loss diagram
Below we can see the profit/loss diagram of the call ratio spread strategy. The long call has strike $25 and premium $1 and the 2 written calls have strike $27 and premium $0.75.
Call ratio spread strategy example
In the daily chart of stock ORCL (below) we notice that the price has visited a strong support (line 1) after a gap down for the first time and in the context of an uptrending market. The possibility of a reversal here is very high but we also worry about the potential of a sideways or even downward move. In case the stock price goes up we believe that in one month it will not break the strong resistance (line 2) at $29. In order to include all three possibilities in a trading strategy (down, sideways, mildly up) we can apply a call ratio spread by being long 1 call strike $26 and premium $1 and short 3 calls strike $29 and premium $0.50. They will all expire after about one month.
The net premium received for opening the position is $50 [($0.50×300)-($1×100)].
If the stock price at expiration is below $26 then all calls are worthless and we have the net credit received as profit ($50), minus commissions.
If the stock at expiration is between the strikes ($26 and $29), our profit is augmented by the amount that the long call is ITM. For example if the stock price at expiration is at $28, then the 3 short options are worthless and the long call produces a profit of $200 [($28-$26)x100], plus the net credit ($250 total). At $29 (higher strike) we achieve the maximum profit which is equal to $350 {[($29-$26)x100]+$50}, minus commissions.
We are starting having losses if the stock price at expiration is above the break-even point of $30.17 [higher strike+(maximum profit/3)]. In this case the 1 short call is counter-balanced from the 1 long call but the other 2 short calls can produce unlimited loss. That’s why a trader must be alert to close the position if the price starts moving against him/her.
Notice that we can close the whole position or any leg suits us at any time before expiration.