How Does The Bull Ratio Spread Work in Options Trading?
What Is A Bull Ratio Spread / Ratio Bull Spread?
A Bull Ratio Spread, or sometimes known as a Ratio Bull Spread, a Call Ratio Spread or a Ratio Call Spread, is a Bull Call Spread enhancement
in order to achieve 3 aims; 1. To result in a higher profit when the underlying stock closes within the strike prices of the long and short options.
2. To reduce risk by eliminating upfront payment for the position. 3. To result in a profit even if the underlying stock stays stagnant or
goes down, getting 3 way profit.
You need to completely understand the Bull Call Spread
in order to apply the Bull Ratio Spread.
What Is A Bull Debit Ratio Spread?
A Bull Debit Ratio Spread is established when the amount of call options that are sold do not cover the amount of money used on the long call options. One would usually put on a Bull Debit Ratio Spread only when one wishes to reduce upfront payment for the Bull Call Spread while limiting losses if the underlying stock should fall instead of rise.
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Example of Bull Debit Ratio Spread:
Assuming QQQQ at $44. Buy To Open 2 QQQQ Jan44Call @ $1.05, Sell To Open 3 QQQQ Jan45Call @ $0.60 In this example, you are selling 1 more Jan45Call than a Bull Call Spread. The net effect is, instead of paying $0.90 to put on this position (as in a bull call spread), you are only paying only $0.30 due to the extra call option sold. |
The advantage of a Bull Debit Ratio Spread versus the Bull Free Ratio Spread or the Bull Credit Ratio Spread is that if the underlying stock should close above the strike price of the short call options, a Bull Debit Ratio Spread stands to lose lesser money than the other two kinds as there are lesser call options sold.
What Is A Bull Free Ratio Spread?
A Bull Free Ratio Spread is established when the amount of call options that are sold exactly covers the amount of money used on the long call options, thus resulting in no cash payment for the position. Again, one would usually put on a Bull Debit Ratio Spread only to not put an upfront payment for the position and do not wish to run the high risk of loss of the credit version should the stock surge suddenly.
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Example of Bull Free Ratio Spread:
Assuming QQQQ at $44. Buy To Open 4 QQQQ Jan44Call @ $1.05, Sell To Open 7 QQQQ Jan45Call @ $0.60 In this example, you are selling 3 more Jan45Call than a Bull Call Spread. |
The advantage of a Bull Free Ratio Spread is that you do not pay cash for it like the Bull Debit Ratio Spread and you stand to lose lesser money than a Bull Credit Ratio Spread if the underlying stock rallies above the strike price of the short call options. However, because more call options are sold than a Bull Debit Ratio Spread, you will lose more money than the Bull Debit Ratio Spread if the stock should rally strongly above the strike price of the short call options.
What Is A Bull Credit Ratio Spread?
A Bull Credit Ratio Spread or sometimes called a Call Credit Ratio Spread, is established when the total cost of the call options that are sold is more than the amount of money being paid on the long call options, thus resulting in a credit. This is the way most option traders want a Bull Ratio Spread to be set up as it returns the highest profit if the underlying stock closes exactly at the strike price of the short call options when compared to the above 2 methods and it is the only way in which the position can profit no matter if the stock goes up, down or stagnant as long as it does not exceed the strike price of the short call options.
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Example of Bull Credit Ratio Spread:
Assuming QQQQ at $44. Buy To Open 4 QQQQ Jan44Call @ $1.05, Sell To Open 10 QQQQ Jan45Call @ $0.60 In this example, you are selling 6 more Jan45Call than a Bull Call Spread. The net effect is, instead of paying $0.90 to put on this position (as in a bull call spread), you recieve ($0.60 x 10) - ($1.05 x 4) = $1.80 as credit for putting on the position. |
The advantage of a Bull Credit Ratio Spread lies in its maximum profit and the ability to make a profit if the underlying stock stays stagnant.
The number of call options you can sell is limited only to the maximum margin granted to your by your broker.
When To Use Bull Ratio Spread?
One should use a bull ratio spread when one is confident in a rise in the underlying instrument up to a certain price. It is a good strategy to maximise profits on stocks that are expected to hit a technical resistance level.
Trading Level Required For Bull Ratio Spread
A Level 5 options trading account that allows the execution of naked options writing is needed for the Bull Ratio Spread as the additional options written are not covered by corresponding long options positions. Read more about Options Account Trading Levels.
Profit Potential of Bull Ratio Spread :
The maximum profit potential of a Bull Ratio Spread is attained when the underlying stock closes at the strike price of the short call options. In this respect, the profit potential of a Bull Ratio Spread is limited. The profitability of a bull ratio spread can also be enhanced or better guaranteed by legging into the position properly.
Profit Calculation of Bull Ratio Spread:
Maximum Return = (Total Credit From Short Call Options + [(Difference in strikes - Price of Long Call) x number of long call contracts])
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Profit Calculation of Bull Debit Ratio Spread:
Assuming QQQQ at $44. Buy To Open 2 QQQQ Jan44Call @ $1.05, Sell To Open 3 QQQQ Jan45Call @ $0.60 Max. Return = (0.6 x 3) + ([(45 - 44) - 1.05] x 2) = $1.70 |
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Profit Calculation of Bull Free Ratio Spread:
Assuming QQQQ at $44. Buy To Open 4 QQQQ Jan44Call @ $1.05, Sell To Open 7 QQQQ Jan45Call @ $0.60 |
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Profit Calculation of Bull Credit Ratio Spread:
Assuming QQQQ at $44. Buy To Open 4 QQQQ Jan44Call @ $1.05, Sell To Open 10 QQQQ Jan45Call @ $0.60 Max. Return = (0.6 x 10) + ([(45 - 44) - 1.05] x 4) = $5.80 |
Risk / Reward of Bull Ratio Spread:
Upside Maximum Profit: Limited
Maximum Loss: Unlimited
Position will start losing money if the stock rises past the strike price of the short call options. However, if the stock falls instead of
rises, then the maximum loss is limited to the net debit (if any).
In this sense, a Bull Free Ratio Spread and a Bull Credit Ratio Spread will
not lose any money if the underlying stock falls. In fact, if the underlying stock falls, a Bull Credit Ratio Spread will still make the
total credit as profit. In this sense, a Bull Ratio Spread is more of a neutral option strategy than a bullish option strategy but because
it achieves it's maximum profit when the underlying stock rises to the strike price of the short call options, it is classified as a bullish
option strategy.
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Break Even Point of Bull Ratio Spread:
The breakeven point of a Bull Ratio Spread is the price beyond which the
position starts to go into a loss.
BEP: Strike Price of Short Call Options + [Maximum Profit / (number of short call options - number of long call options)]
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Breakeven Point of Bull Debit Ratio Spread:
Assuming QQQQ at $44. Buy To Open 2 QQQQ Jan44Call @ $1.05, Sell To Open 3 QQQQ Jan45Call @ $0.60 BEP = 45 + [$1.70 / (3 - 2)] = $46.70 |
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Breakeven Point of Bull Free Ratio Spread:
Assuming QQQQ at $44. Buy To Open 4 QQQQ Jan44Call @ $1.05, Sell To Open 7 QQQQ Jan45Call @ $0.60 BEP = 45 + [$4 / (7 - 4)] = $46.33 |
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Breakeven Point of Bull Credit Ratio Spread:
Assuming QQQQ at $44. Buy To Open 4 QQQQ Jan44Call @ $1.05, Sell To Open 10 QQQQ Jan45Call @ $0.60 BEP = 45 + [$5.80 / (10 - 4)] = $45.97 |
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As you noticed from above, the Bull Credit Ratio Spread has the nearest breakeven point even though it has the highest profit potential.
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Advantages Of Bull Ratio Spread :
:: 3 way profit through the use of a Bull Credit Ratio Spread.
:: Much higher profit can be made than a Bull Call Spread when the underlying stock closes at the strike price of the short call options.
Disadvantages Of Bull Ratio Spread :
:: Some brokers may not allow beginners to execute such a strategy.
:: Margin is required.
Adjustments for Bull Ratio Spread Before Expiration :
1. When the underlying stock reaches the strike price of the short call options before expiration, one may choose to buy back the extra short call options and transform the position into a Bull Call Spread in order to prevent a surge in price past breakeven. This transformation can be automatically performed without monitoring using a Contingent Order.
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