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Option Strategy of the Week

Strategy: Ratio Call

a.k.a. Ratio Call Spread

Ratio Call Option Graph

The Outlook: Bullish. The position will gain if the stock rises by at least the amount of the initial debit. But, not too bullish, since the position can lose on too much of a move.

The Trade: Buy an ATM call, sell two OTM calls.

Gains when: Stock rises but not too far.

Maximum Gain: Limited to the difference in strike prices less the initial debit.

Loses when: Stock does not rise or rises too much.

Maximum Loss : Unlimited.

Breakeven Calculation: Lower breakeven: long strike + initial debit. Upper breakeven: short strike + difference in strike prices - initial debit.

Advantages compared to stock: Leverage, limited loss to downside.

Disadvantages compared to stock: Loss if stock rises too far, no dividends.

Volatility: after entry, increasing implied volatility is negative.

Time: after entry, the passage of time is positive if the stock stays between the breakeven prices.

Margin Requirement : Your broker will see this trade as a bull call and naked short calls. The bull call requires no margin, but the naked short calls will require a minimum of 10% of the strike price plus the premium received, and probably more.

Variations: The short strike can be anywhere you wish, with the long strike below that. Wherever you put the short strike, that is where the "sweet spot" will be.

Comments

  • This strategy might be used if you thought there was a good chance of the stock rising to the short strike before expiration, but not further.
  • The intent of this trade is to be bullish by owning a long call, but help pay for the call by selling two calls at a higher strike.
  • It is possible to enter this strategy for a credit when the implied volatility is high. If you enter for a credit, there is no risk to the downside, and the strategy will benefit from any drop in the implied volatility. However, the implied volatility being high may be a sign the market thinks the stock might have a good move higher, which would cause a loss for the position.
  • Before using this strategy, consider adding an inexpensive long call at a higher strike. That turns the trade into a Butterfly. The Butterfly will maintain about the same risk and reward over the bullish price move you expect, without the unlimited risk if the stock goes too high.
  • Also compare this strategy to a Bull Call, ATM. The entry debit will be higher, but if the stock rises more than you think it will, you can keep the gains instead of giving them all back or having a loss.

Exits

  • This is a psychologically difficult trade. If the stock moves higher as you expect and reaches the short strike before expiration, you may not know what to do. If you hold on and the stock stays where it is, your gains will increase quite a bit just by the passage of time. But if the stock moves higher or lower, you start giving back the gains. The best course of action might be to exit the position if the stock reaches the short strike price, whenever that is.
  • If the stock falls instead of rising, you might try to take about half the maximum loss whenever that happens.

Adjustments

  • If the stock rises near the short strike, it is possible to stick with the trade by buying enough stock to cover half the short calls. Then there is no further risk of loss to the upside, and you may be able to keep the entire gain as if you had entered a bull call. However, you would then have a lot of stock risk and could lose if the stock reverses and goes lower.
 

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