RATIO CALL BACKSPREAD
| Strategy Details | |
| Strategy Type | Bullish |
| # of legs | 3 (Short 1 Lower Strike Call + Long 2 Higher Strike Calls) |
| Maximum Upside Reward | Unlimited, once the underlying crosses above the upper breakeven point |
| Maximum Downside Reward | Limited to the extent of Net Premium Received |
| Maximum Risk | Higher Strike Price - Lower Strike Price - Net Premium Received |
| Upper Breakeven Price | Higher Strike Price + Difference between Higher and Lower Strike - Net Premium Received |
| Lower Breakeven Price | Lower Strike Price + Net Premium Received |
| Payoff Calculation | Payoff of Short Call+ (2 * Payoff of Long Call) |
In the above table, we have assumed the traditional 2:1 ratio wherein the trader is buying 2 Calls and selling 1 Call. However, note that this strategy can be executed using other combinations as well, such as buying 3 Calls and selling 2 Calls, buying 4 Calls and selling 2 Calls, buying 6 Calls and selling 4 Calls etc. The most commonly used long-short ratio to trade this strategy is 2:1 followed by 3:2. For our discussion henceforth, we will assume a total of 3 legs i.e. 1 Call short at a lower strike and 2 Calls long at a higher strike.
Explanation of the Strategy
A Ratio Call Backspread is a strategy that involves selling a lower strike Call option and buying 2 higher strike Call options having the same strike price, same expiration, and same underlying instrument. The lower strike Call that is sold is usually an ATM or an ITM option, while the higher strike Calls that are bought are OTM options. As the number of Calls bought are greater than the number of Calls sold, this is a bullish strategy. Usually, this strategy is a net credit strategy, although sometimes it can be a net debit strategy as well. For our discussion, we will consider this to be a net credit strategy. This strategy has two breakeven points: lower and upper. The strategy is profitable when the underlying price is either below the lower breakeven point or above the upper breakeven point and is unprofitable when the underlying price is in between the two breakeven points. Meanwhile, this strategy has limited risk. Maximum loss under this strategy occurs when the underlying price is exactly at the higher strike price. This is because at this level, both the long Calls are ATM and hence are worthless, whereas the short Call is in a loss-making position as it is ITM.
There are two ways to profit from this strategy: profit on the downside and profit on the upside. On the downside, the trader benefits when the underlying price is below the lower strike price i.e. below the strike price of the short Call. If this happens, the trader will get to keep the entire premium that he/she has received upfront. The trader would also profit if the underlying price is above the lower strike but below the lower breakeven point, although in this case the trader’s profit potential will be reduced. Meanwhile, on the upside, the trader benefits if the underlying price rises above the upper breakeven price. Because the trader is long two Calls as opposed to being short one Call, the profit potential is unlimited once the underlying price moves above the upper breakeven point. Given that the downside profits are quite limited while the upside profits are potentially unlimited, a trader who initiates this strategy would want the underlying price to rise sharply and surge past the upper breakeven point rather than stay below the lower strike price.
Remember, more often than not, this strategy is a net credit strategy, meaning the premium received on shorting the Call is greater than the combined premium paid on buying the two Calls. In fact, this is one of the few strategies that usually has a net credit profile and an unlimited upside potential in case the price rallies sharply. In other words, without making an upfront payment, the trader would have the opportunity to earn unlimited profits on the upside. Hence, from a risk to reward perspective, this strategy is highly attractive. That said, remember that this is a bullish strategy and must be implemented only when one has a strong bullish bias on the underlying. While the trader won’t lose money in case the underlying price falls below the lower strike price, any stagnation in the underlying price between the two breakeven points would cause the trader to suffer losses. So, having a strong conviction that the underlying price will rally sharply is necessary before initiating this strategy.
Benefits of the Strategy
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More often than not, this is a net credit strategy that requires no upfront payment
-
This strategy can profit from a down move in price as well
-
This strategy has an unlimited profit potential in case the underlying rallies sharply
-
This strategy is subject to limited risk
Drawbacks of the Strategy
-
Because this is a volatility-based strategy, stagnating underlying price can lead to losses
-
Because this strategy involves selling an option, it will require a greater margin in your trading account
Strategy Suggestions
-
Ensure that the trend is bullish and that you have a conviction that the underlying price will rally sharply going forward
-
Keep in mind that the number of Calls bought must exceed the number of Calls sold. The ideal long-short ratio for this strategy is 2:1 and to some extent even 3:2
-
When choosing strikes, don’t just randomly select any strike. Remember, you want the underlying price to rise beyond the upper breakeven point, so select strikes accordingly and realistically
-
The difference between the lower strike and the higher strike will be a trade-off between net credit and risk
-
The wider the difference between the two strikes, the larger would the net credit be but so would be the risk, and vice versa. This is because the wider the difference, the farther will the upper breakeven point be, meaning the larger will be the loss-making zone
-
Because this strategy benefits the most when the underlying price rallies sharply, ensure that the underlying instrument being chosen for this strategy is exhibiting volatility
-
Because you have more long Calls than short Calls, Theta will work against you, especially as the underlying price starts rising and inches closer towards the strike of the long Calls
-
Because you have a greater number of long Calls than short Calls and because you want the underlying price to rise sharply, give yourself sufficient time to go right by selecting options that have ample life left
-
Ensure there is sufficient liquidity in the underlying that is being chosen to initiate this strategy
Option Greeks for Ratio Call Backspread
At the time of strategy initiation, the sign of Greeks can vary depending upon the distance between the strike price of a short Call (lower strike) and those of the two long Calls (higher strike). Hence, we shall be talking about Greeks in general without discussing about the sign of each Greek at initiation.
| Greek | Notes |
| Delta | Delta is usually negative at initiation, meaning a fall in the underlying price will benefit the option position. However, if the underlying price rises and moves above the lower breakeven point, Delta will start turning positive, which means a rise in the underlying price will now start benefiting the option position, and vice versa. |
| Gamma | Gamma is initially negligible or slightly negative when the underlying price is at or near the lower strike. It starts rising as the underlying price rises and moves away from the lower strike. This causes the Delta to turn positive and move higher. Gamma peaks out near the higher strike and starts tapering after that. As a result, once the underlying movesabove the higher strike, Delta continues rising but at a slower rate as it approaches its upper extreme. |
| Vega | When the underlying price is below the lower breakeven point, Vega is negative because of which rising volatility hurts the position, and vice versa. However, when the underlying price moves above the lower breakeven point, Vega turns positive because of which rising volatility starts benefiting the position, and vice versa. Vega tends to peak out near the higher strike, above which it starts declining, meaning the impact of volatility on the position will start reducing once the underlying rises above the higher strike. |
| Theta | When the underlying price is below the lower breakeven point, Theta is positive because of which time decay benefits the position. However, when the underlying price rises above the lower breakeven point, Theta turns negative because of which time decay starts hurting the position. Theta bottoms out near the higher strike, meaning it is at this point where the negative impact of time decay is the highest. Once the underlying rises above the higher strike, the two long Calls become ITM, because of which the impact of Theta gradually starts tapering. |
| Rho | As this strategy involves buying two Calls as opposed to writing one Call, Rho turns positive as the underlying price rises and approaches the higher strike. As a result, rising interest rates can benefit the option position at higher levels. That said, this is the least significant of the Greeks, especially in case of short-dated options. |
Payoff of Ratio Call Backspread
The chart below shows the payoff of the Ratio Call Backspread strategy. Observe that the strategy benefits both on the downside and on the upside. See that maximum profit potential on the downside is limited to the extent of the net premium received, and it occurs when the underlying price is below the lower strike. Similarly, see that the maximum profit potential on the upside is unlimited, and it occurs when the underlying price rises above the upper breakeven point. Also observe that in between the two breakeven points, the trader incurs a loss, with maximum loss occurring exactly at the higher strike price.
Example of Ratio Call Backspread
Let us say that Mr. ABC is very bullish on the short-term outlook of Nifty, based on which he has decided to initiate a Ratio Call Backspread strategy, wherein he will sell 1 ITM 9000 Call at ₹430 and buy 2 OTM 9500 Calls at ₹190 each. Let us summarize the details of the strategy below:
- Strike price of shortCall = 9000
- Strike price of longCall = 9500
- Quantity of Calls sold = 1 lot
- Quantity of Calls bought = 2 lots
- ShortCall premium (lower strike) = ₹430
- Long Call premium (higher strike) = ₹190
- Net Credit = ₹50 (430 - 2 * 190)
- Net Credit (in value terms) = ₹3,750 (50 * 75)
- Lower breakeven point = 9050 (9000 + 50)
- Upper breakeven point = 9950 (9500 + 500 - 50)
- Maximum downside reward = ₹3,750
- Maximum upside reward = unlimited
- Maximum risk = ₹33,750 ((9500 - 9000 - 50) * 75)
Now, let us assume a few scenarios in terms of where Nifty would be on the expiration date and the impact this would have on the profitability of the trade.
| Underlying price at Expiration | Net Profit/Loss | Notes |
| 6000 | Profit of ₹3,750 | Payoff = [430-maximum of (6000-9000,0)]+[2*{maximum of (6000-9500,0)-190}]. As the underlying price at expiration is below the lower breakeven price, the trader will make a profit |
| 8000 | Profit of ₹3,750 | Payoff = [430-maximum of (8000-9000,0)]+[2*{maximum of (8000-9500,0)-190}]. As the underlying price at expiration is below the lower breakeven price, the trader will make a profit |
| 8500 | Profit of ₹3,750 | Payoff = [430-maximum of (8500-9000,0)]+[2*{maximum of (8500-9500,0)-190}]. As the underlying price at expiration is below the lower breakeven price, the trader will make a profit |
| 9000 | Profit of ₹3,750 | Payoff = [430-maximum of (9000-9000,0)]+[2*{maximum of (9000-9500,0)-190}]. As the underlying price at expiration is below the lower breakeven price, the trader will make a profit |
| 9025 | Profit of ₹1,875 | Payoff = [430-maximum of (9025-9000,0)]+[2*{maximum of (9025-9500,0)-190}]. As the underlying price at expiration is below the lower breakeven price, the trader will make a profit |
| 9050 | No profit, No loss | Payoff = [430-maximum of (9050-9000,0)]+[2*{maximum of (9050-9500,0)-190}]. As the underlying price at expiration is equal to the lower breakeven price, the trader will neither profit nor incur a loss |
| 9200 | Loss of ₹11,250 | Payoff = [430-maximum of (9200-9000,0)]+[2*{maximum of (9200-9500,0)-190}]. As the underlying price at expiration is between the two breakeven points, the trader will make a loss |
| 9500 | Loss of ₹33,750 | Payoff = [430-maximum of (9500-9000,0)]+[2*{maximum of (9500-9500,0)-190}]. As the underlying price at expiration is between the two breakeven points, the trader will make a loss |
| 9800 | Loss of ₹11,250 | Payoff = [430-maximum of (9800-9000,0)]+[2*{maximum of (9800-9500,0)-190}]. As the underlying price at expiration is between the two breakeven points, the trader will make a loss |
| 9950 | No profit, No loss | Payoff = [430-maximum of (9950-9000,0)]+[2*{maximum of (9950-9500,0)-190}]. As the underlying price at expiration is equal to the upper breakeven price, the trader will neither profit nor incur a loss |
| 12000 | Profit of ₹153,750 | Payoff = [430-maximum of (12000-9000,0)]+[2*{maximum of (12000-9500,0)-190}]. As the underlying price at expiration is above the upper breakeven price, the trader will make a profit |
| 15000 | Profit of ₹378,750 | Payoff = [430-maximum of (15000-9000,0)]+[2*{maximum of (15000-9500,0)-190}]. As the underlying price at expiration is above the upper breakeven price, the trader will make a profit |
Notice in the table that the trader profits from a decline in price as well as from a rise in price. However, compare the profits at both the extremes. It is clear that a trader who initiates this strategy would want the underlying price to rise sharply above the upper breakeven point as this would open door for huge profits. The objective of making this strategy a net credit strategy is to profit even if the underlying price declines below the lower strike. That said, this is an inherently bullish strategy. Meanwhile, also observe that the trader suffers when the underlying price gets stuck in between the two breakeven points, with maximum loss occurring exactly at the higher strike price. This is the zone that any trader who initiates this strategy would want to avoid.
Ratio Put Backspread
| Strategy Details | |
| Strategy Type | Bearish |
| # of legs | 3 (Short 1 Higher Strike Put + Long 2 Lower Strike Puts) |
| Maximum Upside Reward | Limited to the extent of Net Premium Received |
| Maximum Downside Reward | Unlimited, once the underlying crosses below the lower breakeven point |
| Maximum Risk | Higher Strike Price - Lower Strike Price - Net Premium Received |
| Upper Breakeven Price | Higher Strike Price - Net Premium Received |
| Lower Breakeven Price | Lower Strike Price - Difference between Higher and Lower Strike + Net Premium Received |
| Payoff Calculation | Payoff of Short Put+ (2 * Payoff of Long Put) |
In the above table, we have assumed the traditional 2:1 ratio wherein the trader is buying 2 Puts and selling 1 Put. However, note that this strategy can be executed using other combinations as well. The most commonly used long-short ratio is 2:1 followed by 3:2. For our discussion henceforth, we will assume a total of 3 legs i.e. 1 Put short at a higher strike and 2 Puts long at a lower strike.
Explaination of the Strategy
A Ratio Put Backspread is a strategy that involves selling a higher strike Put and simultaneously writing two lower strike Puts having the same strike, underlying, and expiration. As this strategy involves buying a greater number of Puts than selling, this is pre-dominantly a bearish strategy that benefits from a sharp decline in the price of the underlying instrument. Usually, this strategy is executed as a net credit strategy, because doing so enables the trader to make a small gain even if the underlying price moves higher. That said, this strategy can be executed as a net debit strategy as well. For our further discussion, we will be assuming this to be a net credit strategy.
The Ratio Put Backspread has two breakeven points: upper and lower. The strategy benefits if the underlying price is either above the upper breakeven point or below the lower breakeven point. If the underlying price is above the upper breakeven point, maximum profit is limited to the extent of net premium received. On the other hand, if the underlying price is below the lower breakeven point, maximum profit is potentially unlimited. Because of this feature, this is primarily a bearish strategy that must be deployed only when one is very bearish on the underlying and expects it to slump below the lower breakeven point. Meanwhile, the trader suffers a loss if the underlying price gets stuck between the two breakeven points. Maximum loss under this strategy occurs when the underlying is exactly at the lower strike price.
This strategy is highly attractive from a risk/reward perspective because of its limited risk-unlimited reward potential. However, remember that for this strategy to make money, the underlying price will either have to stay above the upper breakeven point or fall below the lower breakeven point. If it gets stuck between the two, the trader will suffer a loss. Hence, it is necessary to keep this in mind when executing this strategy so as to select the right strikes. Also, as this strategy benefits from a sharp move lower in the underlying price, ensure to select the underlying when it is exhibiting volatility, as high volatility is highly beneficial to this strategy.
Benefits of the Strategy
-
This is usually a net credit strategy that requires no upfront payment
-
If this is executed as a net credit strategy, it can profit from an up move in price as well
-
This strategy has an unlimited profit potential in case the underlying falls sharply
-
This strategy has limited risk
Drawbacks of the Strategy
-
Any stagnation in the underlying price between the two breakeven points will lead to losses
-
Because this strategy involves selling an option, it will require a greater margin in your trading account
Strategy Suggestions
-
Ensure that the trend is bearish and that you have conviction that the underlying price will fall sharply going forward
-
Keep in mind that the number of Puts bought must exceed the number of Puts sold. The ideal long-short ratio for this strategy is 2:1 and to some extent even 3:2.
-
When choosing strikes, don’t just randomly select any strike. Remember, you want the underlying price to fall beyond the lower breakeven point, so select strikes accordingly and realistically
-
The difference between the lower strike and the higher strike will be a trade-off between net credit and risk
-
The wider the difference between the two strikes, the larger would the net credit be but so would be the risk, and vice versa. This is because the wider the difference, the farther will the lower breakeven point be, meaning the larger will be the loss-making zone
-
Because this strategy benefits the most when the underlying price falls sharply, ensure that the underlying instrument being chosen for this strategy is exhibiting volatility
-
Because you have more long Puts than short Puts, Theta will work against you, especially as the underlying price starts falling and inches closer towards the strike of the long Puts
-
Because you have a greater number of long Puts than short Puts and because you want the underlying price to fall sharply, give yourself sufficient time to go right by selecting options that have ample life left
-
If there is less time left to expiration and if you still want to deploy this strategy, it would be wiser to execute this as a net debit strategy, so as to narrow the difference between the two strikes
-
Ensure there is sufficient liquidity in the underlying that is being chosen to initiate this strategy
Option Greeks for Ratio Put Backspread
| Greek | Notes |
| Delta | Delta is usually positive at initiation, meaning a rise in the underlying price will benefit the option position. However, if the underlying price drops and moves below the upper breakeven point, Delta will start turning negative, which means a fall in the underlying price will now start benefiting the position, and vice versa. |
| Gamma | Gamma is initially negligible or slightly negative when the underlying price is at or near the higher strike. It starts rising as the underlying price falls and moves awayfrom the higher strike. This causes the Delta to turn negative and move lower. Gamma eventually peaks out near the lower strike and starts tapering after that. As a result, once the underlying drops below the lower strike, Delta continues declining but at a slower rate as it approaches its lower extreme. |
| Vega | When the underlying price is above the upper breakeven point, Vega is negative because of which rising volatility hurts the position, and vice versa. However, when the underlying price drops below the upper breakeven point, Vega turns positive because of which rising volatility starts benefiting the position, and vice versa. Vega tends to peak out near the lower strike, below which it starts declining, meaning the impact of volatility on option position will start reducing once the underlying price drops below the lower strike price. |
| Theta | When the underlying price is above the upper breakeven point, Theta is positive because of which time decay benefits the position. However, when the underlying price drops below the upper breakeven point, Theta turns negative because of which time decay starts hurting the position. Theta bottoms out near the lower strike, meaning it is at this point where the negative impact of time decay is the highest. Once the underlying price declines below the lower strike, the two long Puts become ITM, because of which the impact of Theta gradually starts tapering. |
| Rho | As this strategy involves buying two Puts as opposed to writing one Put, Rho turns negative as the underlying price falls and approaches the lower strike. As a result, rising interest rates can hurt the position at lower levels. That said, this is the least significant of the Greeks, especially in case of short-dated options. |
Payoff of Ratio Put Backspread
The chart below shows the payoff of the Ratio Put Backspread strategy. This strategy has two breakeven points: upper and lower. The region outside the two breakeven points is the profit-making zone, while the region within the two breakeven points is the loss-making zone. As we can see in the chart, as long as the underlying price is at or above the higher strike, the trader gets to keep the entire net premium that he/she has received upfront. Similarly, if the underlying price drops below the lower breakeven point, the trader has the potential to earn unlimited profit, depending on how lower the underlying price falls below the lower breakeven point. Meanwhile, the maximum loss under this strategy occurs when the underlying price is exactly at the lower strike price.
Example of Ratio Put Backspread
Let us say that Mr. ABC is very bearish on the short-term outlook of Reliance Industries, based on which he has decided to initiate a Ratio Put Backspread strategy, wherein he will sell 1 ITM 1220 Put at ₹80 and buy 2 OTM 1100 Puts at ₹30 each. Let us summarize the details of the strategy below:
- Strike price of shortPut = 1220
- Strike price of longPut = 1100
- Quantity of Puts sold = 1 lot
- Quantity of Puts bought = 2 lots
- ShortPut premium (higher strike) = ₹80
- Long Put premium (lower strike) = ₹30
- Net Credit = ₹20 (80 - 2 * 30)
- Net Credit (in value terms) = ₹10,000 (20 * 500)
- Upper breakeven point = 1200 (1220 - 20)
- Lower breakeven point = 1000 (1100 - 120 + 20)
- Maximum upside reward = ₹10,000
- Maximum downside reward = unlimited
- Maximum risk = ₹50,000 ((1220 - 1100 - 20) * 500)
Now, let us assume a few scenarios in terms of where Reliance Industries would be on the expiration date and the impact this would have on the profitability of the trade.
| Underlying price at Expiration | Net Profit/Loss | Notes |
| 1500 | Profit of ₹10,000 | Payoff = [80-maximum of (1220-1500,0)]+[2*{maximum of (1100-1500,0)-30}]. As the underlying price at expiration is above the upper breakeven price, the trader will make a profit |
| 1400 | Profit of ₹10,000 | Payoff = [80-maximum of (1220-1400,0)]+[2*{maximum of (1100-1400,0)-30}]. As the underlying price at expiration is above the upper breakeven price, the trader will make a profit |
| 1220 | Profit of ₹10,000 | Payoff = [80-maximum of (1220-1220,0)]+[2*{maximum of (1100-1220,0)-30}]. As the underlying price at expiration is above the upper breakeven price, the trader will make a profit |
| 1210 | Profit of ₹5,000 | Payoff = [80-maximum of (1220-1210,0)]+[2*{maximum of (1100-1210,0)-30}]. As the underlying price at expiration is above the upper breakeven price, the trader will make a profit |
| 1200 | No profit, No loss | Payoff = [80-maximum of (1220-1200,0)]+[2*{maximum of (1100-1200,0)-30}]. As the underlying price at expiration is equal to the upper breakeven price, the trader will neither make a profit nor incur a loss |
| 1150 | Loss of ₹25,000 | Payoff = [80-maximum of (1220-1150,0)]+[2*{maximum of (1100-1150,0)-30}]. As the underlying price at expiration is between the two breakeven points, the trader will incur a loss |
| 1100 | Loss of ₹50,000 | Payoff = [80-maximum of (1220-1100,0)]+[2*{maximum of (1100-1100,0)-30}]. As the underlying price at expiration is between the two breakeven points, the trader will incur a loss |
| 1050 | Loss of ₹25,000 | Payoff = [80-maximum of (1220-1050,0)]+[2*{maximum of (1100-1050,0)-30}]. As the underlying price at expiration is between the two breakeven points, the trader will incur a loss |
| 1000 | No profit, No loss | Payoff = [80-maximum of (1220-1000,0)]+[2*{maximum of (1100-1000,0)-30}]. As the underlying price at expiration is equal to the lower breakeven price, the trader will neither make a profit nor incur a loss |
| 900 | Profit of ₹50,000 | Payoff = [80-maximum of (1220-900,0)]+[2*{maximum of (1100-900,0)-30}]. As the underlying price at expiration is below the lower breakeven price, the trader will make a profit |
| 800 | Profit of ₹100,000 | Payoff = [80-maximum of (1220-800,0)]+[2*{maximum of (1100-800,0)-30}]. As the underlying price at expiration is below the lower breakeven price, the trader will make a profit |
| 700 | Profit of ₹150,000 | Payoff = [80-maximum of (1220-700,0)]+[2*{maximum of (1100-700,0)-30}]. As the underlying price at expiration is below the lower breakeven price, the trader will make a profit |
Notice in the table that on the upside, no matter how higher the price of Reliance goes above the upper breakeven point, the trader makes a fixed maximum gain of ₹10,000. At the other extreme, observe that the lower the price of Reliance falls below the lower breakeven point, the higher would be the trader’s return. Meanwhile, if Reliance consolidates in between the two breakeven points, the trader will incur a loss. The maximum loss for this strategy is ₹50,000, which occurs when the price of Reliance is exactly at the lower strike price.
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Comments & Discussions in
FYERS Community
shashanka commented on July 15th, 2020 at 5:00 PM
Good day Mr. Tejas,
Thanks for the detailed explanation.
One correction - the P/L chart for the Ratio call backspread and Ration put backspread is the same. Kindly rectify.
Thanks and regards,
Shashanka
Abhishek Chinchalkar commented on July 16th, 2020 at 7:59 AM
Hi Shashanka, thank you for noticing this. We'll make changes at the earliest.