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Short Bull Ratio Spread - Introduction
A Short Bull Ratio Spread, or sometimes known as a Short Ratio Bull Spread, a Short Call Ratio Spread or a Short Ratio Call Spread or a Call Back Spread, is a cousin of the
Bull Ratio Spread. It is a bullish call option strategy which not only eliminates upfront payment, but also allows an unlimited profit potential,
something which the Bull Ratio Spread is unable to achieve.
The Short Bull Ratio Spread is made up of buying At The Money (ATM) or slightly Out Of The Money (OTM) call options and then selling to open
a lesser number of In The Money (ITM), more expensive call options of the same expiration month.
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 or significantly reduce 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.
Short Bull Ratio Spread Example
Assuming QQQQ at $44.
Buy To Open 3 QQQQ Jan44Call @ $1.05, Sell To Open 1 QQQQ Jan41Call @ $3.15
As the 3 Jan44Call costs $1.05 x 3 = $3.15, the 1 Jan41Call actually
covers the entire price of the long call options
resulting in a zero upfront payment.
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The ratio of long and short call options depends largely on the preference of the individual trader. A common ratio is the 3 : 1 ratio spread where
you sell to open 1 In The Money (ITM) call option for every 3 At The Money (ATM) or Out of the Money (OTM) call options that was bought.
What Strike Prices To Use In Short Bull Ratio Spread?
The main deciding factor when determining what ratio
to establish the Short Bull Ratio Spread 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 less In The Money (ITM) call options you would need to
sell in order to cover the price of the long call options 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 profit and the nearer the lower breakeven
point.
3. If the short call options costs more than the long call options, a net credit results which allows the position to make a profit if the underlying
stock falls drastically. This transforms a short bull ratio spread into a volatile option strategy instead of a bullish option strategy.
4. If the number of In The Money (ITM) short call options is equal to or exceeds the number of long call options, the position will lose money when the underlying stock
goes up, essentially eliminating it's effectiveness as a bullish option strategy.
From the guidelines above, it is obvious that 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.
When To Use Short Bull Ratio Spread?
One should use a Short Bull Ratio Spread when one is confident in a strong rise in the underlying instrument and wishes to
profit from that rise without any upfront payment and not lose any money should the stock falls .
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Trading Level Required For Short Bull Ratio Spread
A Level 3 options trading account that allows the execution of debit spreads is needed for the Short Bull Ratio Spread. Read more about Options Account Trading Levels.
Profit Potential of Short Bull Ratio Spread :
The Short Bull Ratio Spread has an unlimited profit potential. It will keep making more profit as long as the underlying stock keep rising. The profitability of a short bull ratio spread can also be enhanced or better guaranteed by legging into the position properly.
Profit Calculation of Short Bull Ratio Spread:
Profit = ((stock price - long call strike) x number of long call options) - ((stock price - short call strike) x number of short call options)
Profit Calculation of Short Bull Ratio Spread
Assuming QQQQ at $44. Buy To Open 3 QQQQ Jan44Call @ $1.05, Sell To Open 1 QQQQ Jan41Call @ $3.15.
Assume QQQQ rises to $47.
Profit = ((47 - 44) x 300) - (((47 - 41) x 100) = 900 - 600 = $300 profit.
Because you paid nothing to put on this position, profit % is infinite. You made money out of nothing.
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Maximum loss = Total Premium Value Of Long Call Options - Total Premium Value Of Short Call Options
Profit Calculation of Short Bull Ratio Spread
Assuming QQQQ at $44. Buy To Open 3 QQQQ Jan44Call @ $1.05, Sell To Open 1 QQQQ Jan41Call @ $3.15.
Maximum Loss = ($1.05 x 300) - (($3.15 - $3) x 100) = $315 - $15 = $300 when QQQQ closes at $44 upon expiration.
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Risk / Reward of Short Bull Ratio Spread:
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 Short Bull Ratio Spread:
There are 2 breakeven points for a Short Bull Ratio Spread. 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 lose only the net debit (if any).
Upper Breakeven Point = (Maximum loss / (number of long call options - number of short call options)) + Strike Price Of Long Call Options
Profit Calculation of Short Bull Ratio Spread
Assuming QQQQ at $44. Buy To Open 3 QQQQ Jan44Call @ $1.05, Sell To Open 1 QQQQ Jan41Call @ $3.15.
Net debit = 0, Maximum Loss = $300
Upper Breakeven Point = (300 / (300 - 100)) + 44 = 1.5 + 44 = $45.50
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Lower Breakeven Point = Strike Price Of the Short Call Options.
Profit Calculation of Short Bull Ratio Spread
Assuming QQQQ at $44. Buy To Open 3 QQQQ Jan44Call @ $1.05, Sell To Open 1 QQQQ Jan41Call @ $3.15.
Net debit = 0
Lower Breakeven Point = $41
If the stock drops below $41, the position will expire with zero profit / loss.
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As you noticed from above, the short bull ratio spread offers the best of both worlds as long as the underlying stock moves significantly up or down.
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Advantages Of Short Bull Ratio Spread :
:: No upfront payment needed for the position.
:: No loss occurs if the underlying stock falls drastically instead of rises.
:: Unlimited profit potential
Disadvantages Of Short Bull Ratio Spread :
:: 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.
Adjustments for Short Bull Ratio Spread Before Expiration :
1. If the position is already in profit and the underlying stock is expected to continue it's rally, one 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.
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