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Strategy of the Week
Ratio Call Spread
Outlook: Bullish. The position will gain if the stock rises by at
least the amount of the initial debit. But, not too bullish, since the
position can lose on too much of a move.
Buy an ATM call, sell two OTM calls.
when: Stock rises but not too far.
Gain: Limited to the difference in strike prices less the initial
when: Stock does not rise or rises too much.
Loss : Unlimited.
Calculation: Lower breakeven: long strike + initial debit. Upper
breakeven: short strike + difference in strike prices - initial debit.
compared to stock: Leverage, limited loss to downside.
compared to stock: Loss if stock rises too far, no dividends.
after entry, increasing implied volatility is negative.
after entry, the passage of time is positive if the stock stays between
the breakeven prices.
Requirement : Your broker will see this trade as a bull call and
naked short calls. The bull call requires no margin, but the naked short
calls will require a minimum of 10% of the strike price plus the premium
received, and probably more.
The short strike can be anywhere you wish, with the long strike below
that. Wherever you put the short strike, that is where the "sweet
spot" will be.
- This strategy
might be used if you thought there was a good chance of the stock rising
to the short strike before expiration, but not further.
- The intent
of this trade is to be bullish by owning a long call, but help pay for
the call by selling two calls at a higher strike.
- It is
possible to enter this strategy for a credit when the implied volatility
is high. If you enter for a credit, there is no risk to the downside,
and the strategy will benefit from any drop in the implied volatility.
However, the implied volatility being high may be a sign the market
thinks the stock might have a good move higher, which would cause a
loss for the position.
using this strategy, consider adding an inexpensive long call at a higher
strike. That turns the trade into a Butterfly.
The Butterfly will maintain about the same risk and reward over the
bullish price move you expect, without the unlimited risk if the stock
goes too high.
- Also compare
this strategy to a Bull
Call, ATM. The entry debit will be higher, but if the stock rises
more than you think it will, you can keep the gains instead of giving
them all back or having a loss.
- This is
a psychologically difficult trade. If the stock moves higher as you
expect and reaches the short strike before expiration, you may not know
what to do. If you hold on and the stock stays where it is, your gains
will increase quite a bit just by the passage of time. But if the stock
moves higher or lower, you start giving back the gains. The best course
of action might be to exit the position if the stock reaches the short
strike price, whenever that is.
- If the
stock falls instead of rising, you might try to take about half the
maximum loss whenever that happens.
- If the
stock rises near the short strike, it is possible to stick with the
trade by buying enough stock to cover half the short calls. Then there
is no further risk of loss to the upside, and you may be able to keep
the entire gain as if you had entered a bull call.
However, you would then have a lot of stock risk and could lose if the
stock reverses and goes lower.