Call Diagonal Ratio Spread

Call Diagonal Ratio Spread Risk Graph
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What Is A Call Diagonal Ratio Spread?


A Call Diagonal Ratio Spread is a diagonal ratio spread with the ability to make a profit in all 3 directions; Upwards, Downwards and Sideways, just like a Call Ratio Spread.

Like the Call Ratio Spread, the only way a Call Diagonal Ratio Spread can lose money is when the underlying stock rallies too strongly. That's right, nothing's perfect in options trading.

Because the Call Diagonal Ratio Spread loses money only when a stock rallies strongly, it has been technically classified as a neutral options strategy even though it does not lose money no matter how much the underlying stock drops.

However, unlike the call ratio spread, the same long call options can be used for several months while short term call options are written against it so that no additional commission is spent on re-establishing the whole position month after month. This makes the Call Diagonal Ratio Spread an improved version of the Call Ratio Spread.

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When To Use Call Diagonal Ratio Spread?


Call Diagonal Ratio Spread should be used when you are confident in a rise in the underlying instrument up to a certain price and wishes to make money even if the stock should remain stagnant or go downwards instead. It is a good options trading strategy to maximise profits on stocks that are expected to hit a technical resistance level and not exceed that level for several months.



How to Execute Call Diagonal Ratio Spreads?



Overview
Call Diagonal Ratio Spreads are established by shorting more out of the money call options than the amount of in the money / at the money call options are bought, resulting in a credit.

Being a diagonal spread, call options with a longer expiration are bought while shorter expiration call options are shorted. This is the main difference between the Call Diagonal Ratio Spread and the Call Ratio Spread. In a Call Ratio Spread, both long and short call options of the same expiration month are used.


Example of Call Diagonal Ratio Spread:

Assuming QQQQ at $44.

Buy To Open 5 contracts of QQQQ Mar44Call @ $1.55, Sell To Open 15 contracts of QQQQ Jan45Call @ $0.60

The net effect is, you recieve ($0.60 x 1500) - ($1.55 x 500) = $125 as credit for putting on the position.


In the above example, 15 contracts of out of the money options are shorted while only 5 contracts of at the money call options are bought. The ratio in this Call Diagonal Ratio Spread is 3 : 1. This means that for every 1 contract of at the money call options bought, 3 contracts of out of the money call options are bought. This is why such options trading strategies are known as Ratio Spreads. Veteran options traders would notice by now that Call Diagonal Ratio Spreads are simply Calendar Call Spreads that sells more out of the money call options than at the money call options.



How to Determine Ratio and Strike Price to Use For Call Diagonal Ratio Spread?


Determining the above ratio depends on which strike price the out of the money call options are shorted. In general, the higher the strike price of the out of the money call options, the lower the price of each contract and hence the more contracts need to be shorted in order to result in a net credit, requiring higher margin. Because longer term call options of the same strike price commands a higher premium, more short term call options need to be shorted in a Call Diagonal Ratio Spread than in a Call Ratio Spread of the same strike price, incurring higher options trading margin. This is the main disadvantage of the Call Diagonal Ratio Spread against the Call Ratio Spread.

Example of Different Strike Prices Call Diagonal Ratio Spread:

Assuming QQQQ at $44.

Mar44Call is trading @ $1.55, Jan45Call is trading @ $0.60, Jan46Call is trading @ $0.25.

If the Jan46Call is chosen for shorting instead of the Jan45Call, you would need to short 36 contracts to achieve the net credit of $180 rather than just shorting 15 contracts using the Jan45Call. Below is a comparison:

($0.25 x 3600) - ($1.55 x 500) = $125 credit using the Jan46Call

($0.60 x 1500) - ($1.55 x 500) = $125 credit using the Jan45Call

Note: Each options contract represents 100 shares, therefore the figure used in the calculation is the number of contracts times 10.

The higher the strike price of the out of the money call options shorted in a Call Diagonal Ratio Spread, the higher the stock can surge before the position starts losing money. This is because when the underlying stock goes above the strike price of the short call options, the short call options start to increase in price faster than the long call options. In our above example, if the Jan46Call are shorted, the position starts losing money only when the QQQQ rises above $46 while if the Jan45Call are shorted, the position starts losing money once the QQQQ rises beyond $45. So the trade off here is really the amount of margin you have versus how far you want the losing point to be. The higher the strike price of the out of the money call options, the farther the losing point of the Call Diagonal Ratio Spread becomes. Stock options trading is all about trade-offs.

The higher the strike price of the out of the money call options shorted in a Call Diagonal Ratio Spread, the higher the maximum profit attainable by the Call Diagonal Ratio Spread will be if the initial net credit is kept the same. However, that also means that the stock needs to rally more in order to attain that maximum profit as the maximum profit attainable by a Call Diagonal Ratio Spread is when the stock closes on the strike price of the short call options upon expiration. Yes, another options trading trade-off.


In an ideal options trading world where margin is not a concern, you would short as many out of the money call options as you want to as far out of the money as possible in order to build a Call Diagonal Ratio Spread with the highest possible net credit, maximum profit and farthest losing point. However, such a world does not exist in options trading and margin is as big concern a in Call Diagonal Ratio Spreads as it is in any options trading strategies involving uncovered short option positions.

If you only have enough margin to short a certain number of options contracts, you can either short a lower strike price or you can buy fewer at the money call options in order to maintain the net credit in the Call Diagonal Ratio Spread. In our Call Diagonal Ratio Spread examples so far, if you have enough options trading margin to short only 15 contracts, you can use a lower strike price in order to maintain the net credit of the Call Diagonal Ratio Spread position by choosing the Jan45Call and not the Jan46Call as 36 contracts of Jan46Call would not result in a net credit. Otherwise, you can buy no more than 3 contracts of Jan44Call and still maintain a net credit with 15 contracts of Jan46Call. Such is the flexibility of options trading.

Example of shorting a lower strike price and buying lesser call options in Call Diagonal Ratio Spread:

Assuming QQQQ at $44 and you have enough margin to short only 15 contracts max.

Jan44Call is trading @ $1.05, Jan45Call is trading @ $0.60, Jan46Call is trading @ $0.25.

Scenario 1: Shorting a Lower Strike.

If you can only short 15 contracts of Jan46Call, you won't be able to cover the price of the 5 contracts of Jan44Call bought at all.

5 Contracts of Jan44Call = $1.05 x 500 = $525. 15 contracts of Jan46Call = $0.25 x 1500 = $375. The position would be a net debit of $150 instead of a net credit. When a Call Diagonal Ratio Spread is a net debit position, it would not be able to make any money if the stock goes down. In this case, you should short the Jan45Calls instead as illustrated in the first example in the overview above.

Scenario 2: Buying lesser call options.

In order to maintain a net credit while shorting 15 contracts of Jan46Call, you should buy no more than 3 contracts of Jan44Call.

15 contracts of Jan46Call = $0.25 x 1500 = $375

3 contracts of Jan44Call = $1.05 x 300 = $315

Net Credit = $375 - $315 = $60

The profitability of a call diagonal ratio spread can be enhanced or better guaranteed by legging into the position properly.





Profit Potential of Call Diagonal Ratio Spread :


The maximum profit potential of a Call Diagonal 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 Call Diagonal Ratio Spread is limited.

Maximum profit point of Call Diagonal Ratio Spread:

Assuming QQQQ at $44.

Buy To Open 5 contracts of QQQQ Jan44Call @ $1.05, Sell To Open 15 contracts of QQQQ Jan45Call @ $0.60

Maximum Profit happens when the QQQQ closes at $45 at expiration of the Jan45Call.




Risk / Reward of Call Diagonal Ratio Spread:



Upside Maximum Profit: Limited

Maximum Loss: Unlimited
Position starts 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 position makes in profit the net credit gained.



Advantages Of Call Diagonal Ratio Spread :



:: 3-way options trading profit.

:: 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.

:: Call options can be written against the long call options for more than just one month.



Disadvantages Of Call Diagonal Ratio Spread :



:: Some brokers may not allow beginners to execute such options trading strategies.

:: Margin is required.

:: More Margin is required than Call Ratio Spread as more options need to be shorted in order to maintain a net credit at the same strike prices.


Alternate Actions Before Expiration :



1. When the underlying stock reaches the strike price of the short call options before expiration, one may choose to buy to close the extra short call options in order to prevent losses due to a surge in price past breakeven.

2. If the underlying stock has exceeded the strike price of the short call options but is expected to correct back down below the strike price of the short call options in the following month, you could roll forward the short call options into the following month in order to anticipate the correction. This is a flexibility you will not get in a Call Ratio Spread.


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