In this post we will learn how to trade the short ratio call spread.
This strategy is traded when a trader has a range-bound view on the stock, but feels that the volatility will decrease in the near future.
Creating the Short Ratio Call Spread:
1) Buy 1 In The Money (ITM) Call Option
2) Sell 2 (or double the number of) Out Of The Money (OTM) Call Options
Note: Refer my article on long call ladder. You will see that in the long call ladder a trader buys one ITM call option and sell one ATM call option and another OTM call option. So what is the difference between long call ladder and the short call ratio trade?
The difference is the credit received and risk in the trade. While in the short ratio call spread the credit received is more, in the long call ladder the credit received is less. Risk is also more in this strategy than the long call ladder because the shorted options are near the money.
Risk vs. Reward:
Risk is Unlimited.
Reward is Limited.
Look at the image below to understand better:
Lets now trade Short Ratio Call Spread using real premiums.
Nifty spot at 8755
INDIA VIX: 21.63
26-Mar-15 CE 8,800.00 213.00 (We will consider this OTM Call Option)
26-Mar-15 CE 8,700.00 266.00 (We will consider this ITM Call Option)
Please note that on the day I was writing this article (23-Feb-2015), VIX was on the higher end so you are seeing such high premiums for at the money options. You may get slightly lower premium when you trade. The higher premium is also due to Budget 2015 which will be declared end of this week.
Lets now trade this using the above premiums. To make math simple we trade 100 shares.
1) Buy 100 ITM Call Option: 266*100 = Rs. 26,600.00 (Debit)
2) Sell 200 OTM Call Option: 213*200 = Rs. 42,600.00 (Credit)
Total Credit: 42600-26600 = Rs. 16,000.00
Note: If you do not go far or deep out of the money, ideally you should get a credit. But risk will also increase. Remember if Nifty keeps going up, this trade will have unlimited loss. So the selection of the strike to short is VERY CRITICAL to the success of this trade.
On the one hand, if you sell the nearest OTM option, you get a large credit, but your risk on the upside is very close. On the other hand, if you go deep out of the money and sell options far away then you may not get a credit and may have to pay cash to trade this. In this case the risk reduces, but reward also decreases.
So Which Strike To Sell?
If you sell options very close out of the money, you are actually taking a bear call. Like in the example above. The trader has got a large credit – so he will be happy if Nifty falls.
If you sell options far out of the money, you are taking a slightly bullish call. Since you paid money to trade you want to profit from both the bought options (for that Nifty has to rise), and the sold options (for that Nifty cannot travel far up). So you would want Nifty to go up slowly.
Therefore I suggest you sell options that far so that you pay a very small amount or get a small credit. This will balance out the bear and bull view and be correct with the strategies view which is range-bound with fall in volatility.
Can you smell the benefits of being a conservative trader? By selling not very far nor very close out of the money options the trader has taken a balanced call. Now, three things can happen:
a) Nifty does not move: Its OK. If the trader took a credit while initiating this trade, he can keep the credit as profits. Or if he paid a small amount the loss is negligible.
b) Nifty goes up: Since the sold calls are still some distance away, chances are that Nifty will take some time to reach the short strike. Now Theta will do its job and take premium away from the sold options. Of course the bought options that are in the money having higher intrinsic value may still be making money. On top of that the decreasing volatility will also eat some premium from the sold options. The trader can exit as soon as Nifty reaches the sold options in profit.
c) Nifty falls: In that case the trader can keep the small credit that he got while initiating this trade. If there was a small debit, that is also fine.
I did not go very far to help you understand the strategy. When you trade take your own call.
This trade has maximum profits when the stock is exactly at the sold option strike on the expiry day. Of course if this happens before expiry, then the trade may be in loss or profit depending on volatility. If volatility dropped significantly, the trade may be in profit. If it increased then the trade may be in loss. It is advisable to take a stop loss when the stock reaches the shorted call option strike as potentially the losses are unlimited if the stock keeps traveling north.
Passage of time and decreasing volatility helps this trade.
Important note: Just to get a large credit please do not sell more options than what is described in this trade. You should only sell double or less number of lots of options than the lots of options bought. If you succeeded trading this once you may get overconfident and sell more options – this is where you may get in trouble.
Lets calculate the profit and loss of the above trade on the expiry day:
1) Nifty at 8700 exactly at the bought option strike:
All options expire worthless. The trader can keep Rs. 16,000.00 or whatever the credit he got while initiating this trade. Note that anything below the results will be same.
Lets calculate return on investment (ROI):
Rs. 13,500 is blocked to sell one lot or 25 shares of Nifty. We sold 200 shares. So total lots sold = 200/25 = 8 * 13500 = Rs. 1,08,000 blocked as margin.
Rs 26,600.00 was blocked for buying 100 shares of 8700 strike call option.
Total money blocked: 1,08,000 + 26,600 = Rs. 1,34,600.00
ROI: (16000 / 134600) * 100 = 11.88%
This is a very good return in 30 days.
2) Nifty at 8800 exactly at the sold option strike (this is the maximum profit zone – please refer image above):
The sold options expire worthless.
Credit from the sold options: Rs. 42,600.00
Calculating loss from the bought options:
The 8700 call option will be 100. So the loss = 100-266 = -166*100 = -16,600.00
Total profit: 42600 – 16600 = Rs. 26,000.00
ROI: (26000 / 134600) * 100 = 19.31%
This is amazing return in 30 days.
3) Nifty at 8900 (profits will start reducing):
8700 Call is 200: 200-266 = -66*100 = -6600
8800 Call is 100: 213-100 = 113*200 = 22600
Total profit: 22600-6600 = Rs. 16,000.00
ROI: (16000 / 134600) * 100 = 11.88%
This is a very good return in 30 days.
4) Nifty at 9000:
8700 Call is 300: 300-266 = 34*100 = 3400
8800 Call is 200: 213-200 = 13*200 = 2600
Total profit: 3400+2600 = Rs. 6,000.00
ROI: (6000 / 134600) * 100 = 4.45%
This is a good return in 30 days.
5) Nifty at 9100 (break even breached – losses begins – here is where you should take a stop loss):
8700 Call is 400: 400-266 = 134*100 = 13400
8800 Call is 300: 213-300 = -87*200 = -17400
Total Loss: 13400-17400 = Rs. -4,000.00
ROI: (-4000 / 134600) * 100 = -2.97%
6) Nifty at 9200 (losses escalates):
8700 Call is 500: 500-266 = 234*100 = 23400
8800 Call is 400: 213-400 = -187*200 = -37400
Total Loss: 23400-37400 = Rs. -14,000.00
ROI: (-14000 / 134600) * 100 = -10.40%
For every 100 points move up the trader will lose Rs. 10,000.00
And virtually since Nifty can move up to infinity – the loss on paper is unlimited. However we all know that somewhere the trader will take stop loss.
Important: This is looking like a great trade as losses only begins after Nifty travels a considerable distance. But you do not know how fast it may happen. If it happens very fast you may lose a lot of money even if you take a stop loss a couple of 100 points away. And since a major event is coming this Saturday (stock markets will remain open like normal trading day), its not the right time to play this trade. If you want to, please let the Budget pass away.
Also once the Budget is over, the premiums of the options will come down drastically because the volatility will crash. Due to this your break even will also get reduced and therefore short ratio call spread will become slightly more risky. If you chose your strike prices correctly and you are ready to take a stop loss, you can trade this strategy.
- Short Ratio Call Spread is done by buying one in the money call option and selling double number of out of the money call option.
- Risk is unlimited, Reward is limited.
- It works best in a range-bound market and volatility dropping.
- You should take a stop loss when the break even is breached. You should have done your calculations before putting the trade.
- Do not trade when a major event is near.
Let me know issues faced in short ratio call spread if you ever traded.
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