Call Ratio Backspread
What it is:
How it works (Example):
Let's say an investor thinks that the stock prices of companies in the widget industry are going to go up. The investor realizes he could be wrong, and he does not have enough cash to purchase as many shares of these companies as he would like.
In a call ratio backspread, the investor could first sell 50 calls of Company XYZ with a strike price of $5 per share (the "short calls"). Because the investor is selling calls and Company XYZ is a hot leader in the industry, he receives $10,000 for the sale of those calls and then uses it to buy 100 calls on with a strike price of $10 per share (the "long calls") in Company ABC, a smaller start-up in the industry. Assume the purchase cost of the ABC calls is $9,750. Notice that because Company ABC is not as "hot" as Company XYZ, the investor is able to use the proceeds from the sale of Company XYZ calls to buy twice as many Company ABC calls -- a 2:1 ratio. Also notice that the investor has $250 left over, which he pockets ($10,000 - $9,750 = $250).
Now, if stock prices go up as we expect, the investor makes money from owning the 100 contracts to buy ABC shares at $10 per share. The XYZ position that he shorted will also go up (which costs him money), but because the investor's long position is twice as big as his short position, the rate at which he makes money exceeds the rate at which he loses money, creating a net gain. This creates unlimited upside potential.
If stock prices go down, the value of the short position and long position both go down, though they don't go down by the same degree. If both positions fall in value, the contracts expire worthless and the investor loses nothing. In fact, the investor made a small amount of money because he paid for the ABC contracts by selling the XYZ contracts and had $250 left over.
If stock prices don't move at all, the ABC stock stays "at the money" (that is, at the $10 strike price), the short XYZ position loses value and the long ABC position will be worthless. This creates an overall loss for the investor, but the loss will not be any larger than the spread between the $5 and $10 strike prices.
Why it Matters:
A call ratio backspread is intended to generate profits when stock prices are going up, and it is intended to do so without risking too much money up-front (although there is usually a margin requirement). An investor must be feeling very bullish to use this strategy. If the investor is wrong in his hunch that prices will go up, the strategy also minimizes the downside. As the example shows, the strategy works best when using volatile stocks, because the biggest potential for loss occurs when the long position stays at the money.