Many traders are familiar with the concept of a “call spread.” A call spread is when you buy one call option and sell another at the same price but with a different expiration date. This strategy can be profitable if there is an increase in volatility between now and when your short-term option expires.
One way to make this strategy more appealing is by converting it into what is called a “ratio spread” Here is an insight into learning how to transform your call spread into ratio spreads.
What Is Call Spread?
In a call spread, you have two option positions with different expiration dates. To create ratio spreads, add one more short-term position in the same contract and an offsetting long-term position of equal size. This allows you to form a rectangle pattern with options sold in ratios instead of prices compared to the longer-term option.
It can be profitable if there is an increase in volatility between now and when your short-term option expires. Therefore, it is used to the advantage of the trader when creating ratio spreads. One way to make this strategy more appealing is by converting it into what is called “ratio spreads.”
What is a Ratio Spread?
Ratio spreads are forms of an options strategy that involves three legs. A trader who uses the ratio spreads creates two contracts on one side and several more contracts on another side.
According to tastytrade, traders should place all the contracts at different strike prices for the same expiration date. The number of strikes in each leg generally needs to be unequal. It ensures symmetry within the trade. Long positions may only compare with certain portions of the short positions. In such a situation, the trader is usually left with uncovered or naked options.
How To Convert Call Spread into Ratio Spread
Ratio spreads can be used in any direction, whether the trader is bearish or bullish. This is because it requires no directional bias and has low margin requirements compared to other strategies.
It also does not require an understanding of implied volatility since only two legs are involved in this strategy. Therefore, it means that it could work well even for beginner traders.
The number of strikes in each leg generally needs to be unequal to ensure symmetry within the trade. It works well when markets are range-bound and profits when the underlying’s price does not move too far away from what has already been invested in it. When markets are volatile, traders can also use this strategy because of its low risk and high margin requirements.
How does Loss occur?
With ratio spreads, the risk of loss is unlimited. In regular spreads, long options match with short options to create a significant price move. However, in ratio spreads, the high number of short positions compared to long positions. This increases the potential of loss significantly.
A loss in the call ratio spreads occurs when the price makes a significant upside jump. It usually happens after selling position more than you have long.
Conversely, a loss is experienced in the put ratio spreads when the price jumps to the downside. It typically occurs after a trader contract more than they long.
In conclusion, converting call spreads to ratio spreads is a great way to generate income for beginner traders. This strategy requires low margin requirements, no directional bias, and is easy to understand.