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Definition: Call Ratio Backspread
Call Ratio Backspread is a investment strategy that uses long and short options to create a portfolio to not only hedge against loss but also gives ability to earn in case prices are favourable. Usually calls are sold and bought in a ratio of 1:2, sometimes 2 call options at lower strike price are sold while 3 call options at higher strike price are purchased. Limited downside risk is due to the property of the call option.
Call Ratio Backspread is used by an investor when he expects that the underlying stock will experience a significant upside.
For Example: Suppose an investor expects a company A’s stock prices to go up in near future. However the investor doesn’t have enough money to purchase many stocks of A. Also he is not very sure of his speculations. Thus he uses options to earn profit.
Consider the stock A is trading at $43 in Jan. The investor executes a 2:1 call backspread by selling 100 call option with March Expiry at strike price of $40 and buying 200 call options with same expiry but with a strike price of $45. Suppose the net cost to enter into the trade for investor is zero.
Thus if at expiry, strike price is $45, then the long calls are worthless while the short March 40 position expires in the money while the long call will be worthless, however buying back these shares will be possible with the gains from the short call position. Thus limiting the losses associated with Bull Call Spread.
However if the stock price rallies up as the investor expected, the gains possible are limitless with the long stock position. However with increased prices his short call position will go into losses. But these losses are less than the gains from longing twice the number of shares he shorted.