Call & Put Ratio Backspread – Options Trading

Call & Put ratio backspread are a part of derivative strategies for options trading. These strategies help to minimise risk and also make a marginal profit when the value of underlying asset decreases sharply. Let us dive in for further insights on both of these strategies.

Call Ratio Backspread

DEFINITION of 'Call Ratio Backspread'

A very bullish investment strategy that combines options to create a spread with limited loss potential and mixed profit potential. It is generally created by selling one call option and then using the collected premium to purchase a greater number of call options at a higher strike price. This options trading strategy has potentially unlimited upside profit because the trader is holding more long call options than short ones.

BREAKING DOWN 'Call Ratio Backspread'

An investor using this strategy would sell fewer calls at a low strike price and buy more calls at a high strike price. The most common ratios used in this strategy are one short call combined with two long calls, or two short calls combined with three long calls. If this strategy is established at a credit, the trader stands to make a small gain if the price of the underlying decreases dramatically.

Put Ratio Backspread

DEFINITION of 'Put Ratio Backspread'

An option trading strategy that combines short puts and long puts to create a position whose profit and loss potential depends on the ratio of these puts. A put ratio backspread is so called because it seeks to profit from the volatility of the underlying stock, and combines short and long puts in a certain ratio at the discretion of the option investor. It is constructed to have unlimited potential profit with limited loss, or limited potential profit with the prospect of unlimited loss, depending on how it is structured. The ratio of long to short puts is typically 2:1, 3:2 or 3:1.

BREAKING DOWN 'Put Ratio Backspread'

For example, a stock trading at ₹29.50 may have one-month puts trading as follows: ₹30 puts trading at ₹1.16 and ₹29 puts trading at 62 cents. A trader who is bearish on the underlying stock and wishes to structure a put ratio backspread that would profit from a decline in the stock, could buy two ₹29 put contracts for a total cost of ₹124 and sell short a ₹30 put contract to receive the ₹116 premium. (Remember that each option contract represents 100 shares). The net cost of this 2:1 put ratio backspread, without taking commissions into account, is therefore ₹8. 

If the stock declines to ₹28 at expiration, the trade breaks even (leaving aside the marginal ₹8 cost of putting on the trade). If the stock falls to ₹27 at option expiry, the gross gain is ₹100; at ₹26, the gross gain is ₹200 and so on. 

If, on the other hand, the stock appreciates to ₹30 by option expiry, the maximum loss is restricted to the cost of the trade or ₹8. The loss is restricted to ₹8 regardless of how high the stock trades by option expiry.