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Call Diagonal Ratio Backspread
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Call Diagonal Ratio Backspread - Introduction
Call Diagonal Ratio Backspreads, also known as Call Calendar Ratio Backspreads, are Ratio Backspreads, which means volatile options strategy. Backspreads profit when the underlying stock breaks out to upside or downside and loses money when the stock remains stagnant. This is what happens with the Call Diagonal Ratio Backspread but with a slight twist. Call Diagonal Ratio Backspreads are credit spreads but retained the unlimited profit potential of debit volatile options trading strategies! Yes, credit backspreads such as the Short Butterfly Spread and Short Condor Spread have only limited profit potential, whereas the Call Diagonal Ratio Backspread has unlimited profit potential when the stock breaks out to upside and limited profit potential when the stock breaks out to downside, opening up one direction for unlimited profit. This tutorial shall cover how Call Diagonal Ratio Backspreads work, when to use it, how to use it and its advantages and disadvantages.
More a Bullish Strategy than a Volatile Strategy
The Call Diagonal Ratio Backspread is a diagonal ratio spread. Even though the Call Diagonal Ratio Backspread is technically a volatile options trading strategy due to the fact that it can profit either upwards or downwards, it does has a strong directional bias, which is upwards. Yes, Call Diagonal Ratio Backspreads can be better understood as a bullish options strategy which still makes a limit amount of money even if the stock goes down strongly. It makes an unlimited profit if the stock goes up and a small profit if the stock goes down. Of course, like all bullish options trading strategies, it loses money if the stock stays still. If understood this way, the Call Diagonal Ratio Backspread becomes the only credit bullish options strategy to have unlimited profit potential. Indeed, the Call Diagonal Ratio Backspread does empitomize the versatility and flexbility of ratio spreads, creating unique options trading risk/reward profiles.
Comparing Call Diagonal Ratio Backspread with Call Ratio Backspread
So, how does the Call Diagonal Ratio Backspread compare with its cousin, the Call (Vertical) Ratio Backspread? Both Call Diagonal Ratio Backspread and the Call Ratio Backspread share the exact same risk/reward profile and used in largely the same situations, so what set them apart?
In terms of how both options trading strategies are set up, the Call Diagonal Ratio Backspread buys further month call options while the Call Ratio Backspread buys call options of the same month as the call options that are being shorted.
Because Call Diagonal Ratio Spread buys further term call options than the Call Ratio Backspread, it incurs a higher cost as the longer term call options are more expensive and consequently makes a lower net credit than the Call Ratio Backspread as well as a lower profit when the stock rallies.
So, what's the advantage of the Call Diagonal Ratio Backspread?
The Call Diagonal Ratio Backspread's only advantage lies in the fact that if the stock did not move on the immediate month, it can write new options against it in the following month and have a second chance at the stock breaking out again! Yes, having a much higher holding power and waiting power greatly increases the chances of the Call Diagonal Ratio Backspread winning versus the Call Ratio Backspread at the cost of lower profits. Yes, this is the kind of trade-off that you get all the time in options trading. If you are very confident of a quick breakout, then you would naturally maximize your profits by using the Call Ratio Backspread instead.
When To Use Call Diagonal Ratio Backspread?
One should use a Call Diagonal Ratio Backspread when one is confident in a strong rise in the underlying instrument , wishes to profit from that rise without any upfront payment , not lose any money should the stock falls and wants to give the stock more time to perform that breakout .
How To Execute Call Diagonal Ratio Backspread?
The Call Diagonal Ratio Backspread involves buying more at the money or out of the money long term call options than the number of short term in the money call options are shorted.
Buy 2 X Long Term ATM Call + Sell 1 x Near Term ITM Call
Because In The Money (ITM) call options costs more than At The Money (ATM) or Out of the Money (OTM) call options, a lesser number of In The Money (ITM) call options is needed to cover the cost of the ATM or OTM options while still gaining in value slower than the combined number of ATM or OTM options when the underlying stock rises.
The ratio of long and short call options depends largely on the preference of the individual trader. A common ratio is the 2 : 1 ratio spread where you sell to open 1 In The Money (ITM) call option for every 2 At The Money (ATM) or Out of the Money (OTM) call options that was bought.
What Strike Prices To Use In Call Diagonal Ratio Backspread?
The main deciding factor when determining what ratio to establish the Call Diagonal Ratio Backspread with is strike price. Here are the effects of different strike prices being used :
1. The wider the strike price difference between the short and long call options, the lesser In The Money (ITM) call options you would need to sell in order to cover the price of the long call options, the bigger the profit if the stock goes down but the further the lower breakeven point becomes.
2. The narrower the strike price difference between the short and long call options, the higher the potential upside profit and the nearer the lower breakeven point, but the lower the profit would be if the stock goes down instead.
From the guidelines above, it is obvious that the higher we expect the net credit to be, the lower the stock needs to drop in order to profit to downside. This is the kind of compromise every options traders should be familar with in options trading. As such, we should always choose to sell the nearest in the money (ITM) call options which covers the total price of the long call options without exceeding the number of long call options bought.
The profitability of a call diagonal ratio backspread can be enhanced or better guaranteed by legging into the position properly.
Profit Potential of Call Diagonal Ratio Backspread :
The Call Diagonal Ratio Backspread has an unlimited profit potential to upside and will keep making more profit as long as the underlying stock keeps rising. It also has limit profit potential to downside and will make the net credit as profit if the stock drops below the lower breakeven point.
Profit Calculation of Call Diagonal Ratio Backspread:
Profit = (Profit on Long Calls) - (Loss on Short Calls)
Maximum loss = Intrinsic Value of short call options - total credit recieved
Risk / Reward of Call Diagonal Ratio Backspread:
Upside Maximum Profit: Unlimited
Maximum Loss: limited
Maximum loss occurs when the underlying stock closes exactly at the strike price of the Long Call Options.
Break Even Point of Call Diagonal Ratio Backspread:
There are 2 breakeven points for a Call Diagonal Ratio Backspread. The Upper Breakeven Point is point above which the position will start to make a profit. The Lower Breakeven Point is the point below which the position will make in profit the net credit received.
Upper Breakeven Point = long call strike + (number of contracts sold x Difference Between Strike) - net credit
Lower Breakeven Point = strike price of short call + (net credit / contracts sold)
Advantages Of Call Diagonal Ratio Backspread :
:: Credit Spread, no upfront payment needed
:: Unlimited profit potential to upside and limit profit potential to downside
Disadvantages Of Call Diagonal Ratio Backspread :
:: Broker needs to allow the trading of credit spreads
:: Makes less profit than a long call option strategy on the same rise in the underlying stock
Alternate Actions Before Expiration :
1. If the position is already in profit and the underlying stock is expected to continue it's rally, you could buy to close the short call options, transforming the position into a Long Call Option in order to maximise profits.
2. If the position is in profit and the underlying stock is expected to reach a certain price by expiration or stay stagnant at a certain higher price, one could buy to close the short call options and then sell to open call options at the strike price which the underlying stock is expected to rise to. This transforms the position into a Bull Call Spread.
3. If the underlying stock fails to move beyond either breakeven point by expiration of the near term call options, roll those short call options into the next further month. This is the advantage Call Ratio Backspread does not have.