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Volatile markets can be traded in any number of ways, including the simple purchase of a straddle or strangle – or, for more sophisticated traders, by way of short butterflies or condors.
But for those middle-level traders who’ve had success with ratio spreads, the call ratio backspread offers a comfortable alternative. Without the initial cost of straddles and strangles and without the complexity of the “airborne” strategies, the call ratio backspread is perfect for anyone who sees a big move coming, suspects it will be to the upside, and wants to limit any potential loss on the trade.
Minimizing Costs and Losses
The call ratio backspread is initiated with the sale of an in-the-money call and the purchase of two or more at-the-money calls, such that a net credit on the trade is created.
That credit is fundamental to the strategy, as it serves to alleviate any loss that might ensue should the underlying either:
- Fail to move in the explosive manner expected; or
- Take too long to do so.
Let’s take a look at a real-life trading example to better understand how it works.
Below is six months’ worth of trade in China’s Google equivalent, Baidu (NASDAQ: BIDU), a stock that’s no stranger to volatility.
The Setup
After losing more than 50% of its value, peak-to-trough, in under a month of trading, shares of Baidu begin to consolidate in the $140-$150 range in early September. You expect the sideways movement to continue, but your research also points to a likely snap higher before too long.
You decide to employ a call ratio backspread expiring in November, because that strategy offers you the best chance of profits should the breakout be in either direction, while at the same time limiting your downside if you’re wrong.
With shares of Baidu sitting at exactly $150, you open the first leg of the trade by selling the in-the-money November 145 call for $9. The second leg is a purchase of two at-the-money 150 calls for $4 each. Your total credit on the trade is $1.
Winning in Both Directions
At that point the shares drift lower, toward $130, leaving you worried about making big money on the trade. But you’re not too worried, either, because if the shares do close at $130 at expiry, all of your options will expire worthless, and you’ll still have your initial $100 credit.
Then it happens.
Baidu takes off in dramatic fashion, climbing better than 50% to close at $205 by expiry.
And your profit breakdown is as follows:
- The short calls are in the money $60 for a loss of $6,000.
- But the two long calls are in the money to the tune of $55 each.
- You therefore net out $5,100 on the trade ($5,500 + $5,500 –$6,000 + $100).
And that’s a great gain.
And if you lose?
Ratio backspreads offer potentially unlimited profits if the price of the underlying rises dramatically, while maximum losses occur when the stock closes at the long call strike by expiry.
In this case, that loss would occur if Baidu was trading at $150. At that level, the long calls would expire worthless, and the short call would be $5 in the money, for a $400 net loss, including the initial credit.
Best of luck!
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