Ratio Call Backspread

Overview

Pattern evolution:

When to use: Normally entered when market is near B and shows signs of increasing activity, with greater probability to upside.

Profit characteristics: Profit limited on downside (if net credit taken in when position was established) but open-ended in rallying market.

Loss characteristics: Maximum loss, is amount of B – A – initial credit (or B – A + initial debit), realized if market is at B at expiration. This loss is less than for equivalent long straddle, the trade-off for sacrificing profit potential on the downside.

Decay characteristics: Dependent on the net time value purchased or sold via this strategy. If more time value sold than bought, then time value decays work to the benefit of the holder.

CATEGORY:Precision
Short call A, long 2 or more calls B

Example

Scenario:
This trader notices the low implied volatility of the options. The expectation now is for the Eurodollar market to rally. But, the trader does not want to lose money if the market moves the other way. A strategy that fits this outlook fairly well is the call ratio backspread.

Specifics:
Underlying Futures Contract: March Eurodollar
Futures Price Level: 90.00
Days to Futures Expiration: 60
Days to Option Expiration: 40
Option Implied Volatility: 14.6%
Option Position:

Short 1 Mar 90.00 Call	+ 0.19 ($475.00)
Long 1 Dec 1.0000 Put
Long 2 Mar 90.25 Calls	– 0.09 ($225.00) x 2
	+ 0.01 ($ 25.00)

At Expiration:
Breakeven: 90.49 (90.25 strike + 0.25 difference between strikes – 0.01 credit).
Loss Risk: Limited to 0.24 ($600); occurs only at 90.25 strike.
Potential Gain: Unlimited; gains mount as futures rise above the 90.49 breakeven point.

Things to Watch:
The worst situation would be a slow drifting of the price up toward the strike of purchased calls. Increased volatility helps this position, so the trader wants large upward price moves.