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Know Your Options

Ratio Back Call Spreads are a strategy I seldom hear anybody talk about.

But they can be a great way to position yourself in a trade if you think something big could happen. And, if you're right, you can use them to maximize your potential returns while at the same time lowering your cost of entry. In fact, you can even put these on as a credit – meaning you'd get paid to place this trade.

But we're going to focus on the more traditional (yet still rarely talked about) way to place this trade.

And once again, the strategy works best if you expect a big move to occur.

Here’s an example of how it works:

Let's say a particular stock was selling at $135. Let's also assume we're going to put on an out-of-the-money, ratio back call spread with 4 months of time on it.

  1. You'll be selling one out-of-the-money call option
    (Let's say the 140 call at 11.25)

  2. You'll also buy two further out-of-the-money calls
    (Let's say the 150 calls for 7.50 each or 15 total)

  • On the one you wrote, you'll collect a premium.

  • On the two you bought, you'll pay a premium.

  • Net investment on the trade = $375
    (Paid $1,500 for the two calls I bought and collected $1,125 for the one I wrote = net cost of $375.)

With me so far?

Next, let's say the one I wrote had a delta of .50.

And the two I bought each had a delta of .39 for a total of .78.

What's my position's net delta?

If my purchased calls are gaining .78 of the underlying stock move, but my written call is losing .50 of the stock's move, my net delta is a positive .28.

Which means, at the beginning, for every dollar rise, my position will gain in value 28% of that.

Why would I do this?

For one, my cost is now only $375 for the trade. If I were to do a regular call buy for that price, I'd have to go all the way out to the 165 call, for instance, and likely get an even smaller delta - meaning it would profit more slowly.

But the real reason is this: It's a cheaper way to get into a position, and you're hoping to capitalize on the increase in delta (which means ultimately an accelerated increase in the value of this position) if a big move occurs.

The 150 calls I bought in this example are $15 out-of-the-money and have a delta of .39 each.

The 165 call by comparison is $30 out-of-the-money and has a delta of .24.

However, as the stock moves up, the closer strikes will see their delta increase more than the further out strike.

So, for example, if the stock now went up to $150, the 140 call would likely have a delta of around .70.

And the two 150 calls I bought would have a delta of around .58 each or 1.16 total.

That means my position's net delta is around .46. And my back call spread likely more than doubled in value by this time.

The 165 call by comparison would likely only see its delta increase to around 38.

As the stock continues to climb, the calls I bought that are now in-the-money will continue to increase in value more so than the further outs, thus giving me a bigger profit potential.

What's the downside?

The downside is that at expiration, if the option I wrote is in-the-money (don't forget, that's the part of the trade that's working against me in a sense) I'm losing on that end.

And if the ones I bought are out-of-the money, or even at-the-money, I've lost the full value of those.

So if I collected $1,125 on the 140 call -- that's now worth $1,000 at expiration, which means I've actually 'made' $125. But another way of looking at this is that I 'gave up' in a sense, $1,000 in premium.

On the two 150 calls I bought, I've lost the entire value of those, which was $1,500 total.

$1,500 - $125 = -$1,375 loss.

Alternatively, if the entire back call spread was in the money at expiration, then I'm for the most part 'OK'. In general, if the spread is $10 wide, you'll need to see the options you bought be at least $10 in the money to not lose at expiration.

But the way to really make this trade work, in my opinion, is to sell while there's plenty of time left. You're looking for options with increased volatility and you’re expecting a big move. This strategy will help you get into a stronger delta position, which means making more while spending less.

Now, since it's a ratio, you can do 3 buys for each 1 call you sell. Your profits will be bigger. But of course, so would your risk. But if you have a strong conviction on the market, this is an excellent way to approach it.

Next time, we'll talk about how to place this trade as a credit, meaning you'll collect a net premium instead of paying a premium.

You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

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