Similar to a long call spread, the call ratio spread is implemented when a trader expects modest upside from the underlying security. However, the stakes are higher in this variation, as the trader sells more calls than are purchased -- most often using a ratio of 2:1. Rather than the limited risk/limited reward setup offered by a 1:1 spread, the ratio spread trader is now faced with unlimited risk and a still-limited reward. As a result, this tactic requires that the trader have a high degree of confidence regarding the stock's expected trajectory on the charts.
Let's take a closer look at the call ratio spread by considering a hypothetical.
Stock XYZ is trekking steadily higher, but the looming $35 level has served as a technical ceiling for years. You expect the uptrend to continue over the near term before stalling out at this familiar resistance level.
To take advantage, you initiate a call ratio spread by buying to open one at-the-money 30-strike call for the ask price of 1.01, and simultaneously selling to open two 35-strike calls for the bid price of 0.15 each. Subtracting your credit of 0.30 (0.15 x 2) on the sold calls from your cost of 1.01 on the purchased call, the spread was initiated for a net debit of 0.71. Accounting for 100 shares per contract, your cost of entry is $71.
The best-case scenario is for XYZ to close squarely at $35 upon expiration. This would return the maximum gain on your purchased call, while both of the sold calls could be left to expire worthless. Your potential profit here is limited to the difference between the two strike prices, less the initial net debit -- or [(35 - 30) - 0.71] = 4.29. Based on 100 shares per contract, that's a total possible win of $429.
Smaller gains can be collected on a close anywhere between $35 and the lower breakeven of $30.71, which is calculated by adding the net debit to the purchased call strike.
If XYZ remains at or below $30 through expiration, your initial net debit of 0.71, or $71, is the most you can lose on the call ratio spread.
If the stock should rise above the strike price of your sold calls, you could be facing steep losses. Only one of the calls you sold is hedged by a purchased call, so your other sold call is naked -- exposing you to theoretically unlimited risk if the shares should rally. Your upper breakeven on this naked call is equivalent to the sold call strike plus the maximum profit of 4.29 on the other leg of the trade, or 35 + 4.29 = 39.29. If the stock should rise above that upper threshold, your losses will add up quickly.
Since the call ratio spread involves more sold calls than purchased calls, it's best if implied volatility remains relatively stable. Rising implied volatility will increase the value of your purchased call, but it also ups the premiums of your sold calls.
Depending upon your strike selection and the ratio of sold calls to purchased calls, you may be able to enter the call ratio spread for a net credit. If so, this changes your potential profit/loss scenarios.
If the stock remains at or below the purchased call strike through expiration, you'll keep the initial credit as your only gain. Meanwhile, additional profits will begin to accrue immediately on a rise above the purchased strike, with the maximum gain equivalent to the difference between the two strike prices, plus the net credit. Should the shares rise above the sold call strike, losses will begin to add up if the stock tops the upper breakeven -- which is equal to the sold strike plus the maximum profit.
Due to the naked call(s) involved in this strategy, a margin account is required to play the call ratio spread. In other words, this strategy is best reserved for experienced option players.