you’re good to go. Both the options would
expire O TM and worthless, and you’d keep
the $0.55 credit as profit.
On the other hand, if the stock drops
below $165 prior to or at expiration, then
the trade could start to gain value. The trade
would hit its breakeven price with the stock
at $164.45 ($0.55 below the $165 strike), and
your spread would hit the maximum loss
if the stock drops to $160 or below. At that
point the vertical spread you sold for $0.55
would now be worth its maximum value of
$5, handing you a loss of $4.45. While this
outcome may be unlikely, be prepared. Of
course, you can always attempt to close your
trade prior to expiration if the market isn’t
moving as you expected.
Call Ratio Backspread
Experiment with this strategy if you
think the market is moving signifi-
cantly higher or pulling back considerably—
none of this “in-between” stuff, because a
move that’s only moderately higher could be
a problem closer to expiration. That’s why
many traders engage the call ratio back-
spread strategy with options further out in
time, say, 90 days or longer.
This approach consists of a short O TM
call that’s closer to the money and has twice
as many long calls at a higher strike. The
idea is to create a trade whose entry price is
preferably a credit. But the trade can also be
placed for “even money” or a small debit. In
short, if the market drops, there’s no harm,
because all the options expire worthless.
And if the market rips higher, the profit
from the two long calls outpaces the loss of
the short call.
As an example (Figure 3), say the underlying is trading at $179. You could sell the $185
call for $4.50 and buy two 195 calls for $2.19
each, or $4.38. With these prices, the net
cost comes to a credit of $0.12 ($4.50–
$5.05), plus transaction costs. But the risk
of the trade is the difference between the
strikes, less the entry credit (or, plus the
entry debit). In this case, it’d be $9.88.
Where’s the risk? If the stock runs
through the short strike of $185, but stops
at the long strike of $195, the short $185 call
loses $10 without the $195 calls pitching in
any help. Knocking off the entry credit of
$0.12 leaves you with the maximum loss of
$9.88 if the stock sits at $195 at expiration.
When trading this strategy, some opt to look
at options further out in time and close the
trade perhaps 30 days before expiration if
the stock is anywhere near either strike.
With plenty of time left until expiration,
if the stock moves high enough, the profits
from the two long options can start to out-
pace the losses from the one short option.
So, even though the $195 call will have a
smaller delta compared to the $185 call, be-
cause there are two of them, the trade’s net
delta could be positive. From another angle,
the losses from the $185 call are offset by the
$195 call, except for the $10 difference be-
tween the two. That leaves the second $195
call free to profit without a cap.
Likewise, if the underlying stock moves
lower, and the spread moves further O TM,
then all the option prices move toward
zero. Because you initiated the trade for
a credit, if the options expire worthless,
you’d actually make a little profit, less
transaction costs, despite being wrong on
the direction of the stock.
EACH OF THESE UNIQUE STRATEGIES
has defined risk and relatively small capital
requirements. But they also offer a chance for
profit and greater flexibility depending on
your perception of a rally or a bounce. Keep
your head when markets can’t make up their
minds—or when the tantalizing branches at
the tops of majestic sequoias call to you.
Kevin Lund is not a representative of TD Ameritrade,
Inc. The material, views, and opinions expressed in
this article are solely those of the author and may
not be reflective of those held by TD Ameritrade, Inc.
For more on the risks of trading and trading options,
see page 37, #1– 2.
FIGURE 2: Short put vertical spread. From the Trade tab, enter a symbol and view the option
chain of the puts. Source: thinkorswim® from TD Ameritrade. For illustrative purposes only.
FIGURE 3: Call ratio backspread. From the option chain on your thinkorswim platform, consider
calls that are further out in expiration. Source: thinkorswim® from TD Ameritrade. For illustrative purposes only.
185 call Buy two