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.
Find Options Strategies With Similar Risk Profiles |
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.
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.
Call Diagonal Ratio Backspread Example:
Assuming QQQQ at $44. Call Diagonal Ratio Backspread : Buys 2 contracts of February44Call, Sells 1 contract of January40Call |
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.
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 .
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.
Call Diagonal Ratio Backspread Example:
Assuming QQQQ at $44. As the 2 Feb44Call costs $1.55 x 2 = $3.10, the 1 Jan40Call actually covers the entire price of the long call options and results in a net credit of $1.00. |
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.
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.
STOCK PICK MASTER!
"Probably The Most Accurate Stock Picks In The World..."
Profit = (Profit on Long Calls) - (Loss on Short Calls)
Profit Calculation of Call Diagonal Ratio Backspread:
Assuming QQQQ at $44. Buy To Open 2 QQQQ Feb44Call @ $1.55, Sell To Open 1 QQQQ Jan40Call @ $4.10. Assume QQQQ rises to $50 during January expiration, Feb44Call rises to $6.05 and Jan40Call rises to $10.00 Profit = (6.05 - 1.55) x 200 - (10.00 - 4.10) x 100 = 900 - 590 = $310 profit Because you paid nothing to put on this position, profit % is infinite. You made money out of nothing. |
Maximum loss = Intrinsic Value of short call options - total credit recieved
Maximum Loss Calculation of Call Diagonal Ratio Backspread:
Assuming QQQQ at $44. Buy To Open 2 QQQQ Feb44Call @ $1.55, Sell To Open 1 QQQQ Jan40Call @ $4.10. Maximum Loss = $400 - $100 = $300 when QQQQ closes at $44 upon expiration. |
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.
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
Profit Calculation of Call Diagonal Ratio Backspread:
Assuming QQQQ at $44. Buy To Open 2 contracts of QQQQ Feb44Call @ $1.55, Sell To Open 1 contract of QQQQ Jan40Call @ $4.10. Net credit = $1.00 Upper Breakeven Point = 44 + (1 x 4) - 1 = $47.00 |
Lower Breakeven Point = strike price of short call + (net credit / contracts sold)
Profit Calculation of Call Diagonal Ratio Backspread:
Continuing from the previous example: Lower Breakeven Point = 40 + (1.00 / 1) = $41.00 |
As you noticed from above, the Call Diagonal Ratio Backspread offers the best of both worlds as long as the underlying stock moves significantly up or down. |
:: Credit Spread, no upfront payment needed
:: Unlimited profit potential to upside and limit profit potential to downside
:: 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
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.
Don't Know If This Is The Right Option Strategy For You? Try our Option Strategy Selector! |
Javascript Tree Menu |