Profits and losses
If the share price is at the higher strike price of the spread at expiry, the maximum profit point will be reached. The potential for profit is partly dependent on how many calls have been sold against each call taken. Generally the ratios are opened on a 1:2 basis and rarely higher than 1:3 due to the increased risk this would introduce should the shares rise strongly.
If the shares fall, the trader can lose no more than the cost of the spread. This protection against a fall in the price of the shares is greater than in the case of a bull call spread due to the higher number of written positions in place. However, if a strong upward movement occurs unexpectedly the trader faces potentially unlimited losses. The higher the number of unprotected calls that have been written, the larger the loss that could be incurred.
Ideally, the spread is opened for a profit, which involves no risk if the shares fall.
- Market strengthens: the ratio call spread provides good protection for the investor in the event of a market downturn. The price of this protection is the possibility of a loss should the market move further upwards than expected.
- Exercise: because the strategy involves uncovered written positions, the risk of exercise must be considered. The trader must meet the collateral requirements of the uncovered calls.
The main threat to the ratio call spread comes from a greater than expected strengthening in the market. If this occurs, the trader may consider closing out the spread, or alternatively closing out the sold options to reduce the risk of exercise.
If the share price falls dramatically, the trader may buy back the long call before it loses too much time value. The danger in closing out the long position is that a market reversal leaves the trader totally exposed on the short legs.
Points to remember
- This strategy benefits from a small upward movement in the market. It should not be used if a strong upward movement is expected.
- Be wary of constructing the strategy on a ratio higher than 1:2.
- Be prepared to act quickly if the share price jumps unexpectedly.