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optionsplaybook.com  2 - Options Playbook

Front Spread w/Calls

AKA RATIO VERTICAL SPREAD

Call ratio vertical spread - Options Playbook

NOTE: This graph assumes the strategy was established for a net credit.

The strategy

Buying the call gives you the right to buy stock at strike price A. Selling the two calls gives you the obligation to sell stock at strike price B if the options are assigned.

This strategy enables you to purchase a call that is at-the-money or slightly out-of-the-money without paying full price. The goal is to obtain the call with strike A for a credit or a very small debit by selling the two calls with strike B.

Ideally, you want a slight rise in stock price to strike B. But watch out. Although one of the calls you sold is “covered” by the call you buy with strike A, the second call you sold is “uncovered,” exposing you to theoretically unlimited risk.

If the stock goes too high, you’ll be in for a world of hurt. So beware of any abnormal moves in stock price and have a stop-loss plan in place.

Options guys tips

Some investors may wish to run this strategy using index options rather than options on individual stocks. That’s because historically, indexes have not been as volatile as individual stocks. Fluctuations in an index’s component stock prices tend to cancel one another out, lessening the volatility of the index as a whole.

The maximum value of a front spread is usually achieved when it’s close to expiration. You may wish to consider running this strategy shorter-term; e.g., 30-45 days from expiration.

If you’re not approved to sell uncovered calls ,consider buying the stock at the same time you set up this strategy. That way, the second call won’t be uncovered, and this strategy will be like a covered call on steroids.

The setup

  • Buy a call, strike price A
  • Sell two calls, strike price B
  • Generally, the stock will be below or at strike A

NOTE: All options have the same expiration month.

Who should run it

All-Stars only

NOTE: Due to the unlimited risk if the stock moves significantly higher, this strategy is suited only to the most advanced option traders. If you are not an All-Star trader, consider running a skip strike butterfly with calls .

When to run it

Options Playbook image 1

You’re slightly bullish. You want the stock to rise to strike B and then stop.

Break-even at expiration

If established for a net debit, there are two break-even points:

  • Strike A plus net debit paid to establish the position.
  • Strike B plus the maximum profit potential.

If established for a net credit, there is only one break-even point:

  • Strike B plus the maximum profit potential.

The sweet spot

You want the stock price exactly at strike B at expiration.

Maximum potential profit

If established for a net debit, potential profit is limited tothe difference between strike A and strike B, minus thenet debit paid.

If established for a net credit, potential profit is limited tothe difference between strike A and strike B, plus the net credit.

Maximum potential loss

If established for a net debit:

  • Risk is limited to the debit paid for the spread if the stock price goes down.
  • Risk is unlimited if the stock price goes way, way up.

If established for a net credit:

  • Risk is unlimited if the stock price goes way, way up.

Margin requirement

Margin requirement is the requirement for the uncovered short call portion of the front spread.

NOTE: If established for a net credit, the proceeds may be applied to the initial margin requirement.

After this position is established, an ongoing maintenance margin requirement may apply. That means depending on how the underlying performs, an increase (or decrease) in the required margin is possible. Keep in mind this requirement is subject to change and is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.

As time goes by

For this strategy, time decay is your friend. It’s eroding the value of the option you purchased (bad). However, that will be outweighed by the decrease in value of the two options you sold (good).

Implied volatility

After the strategy is established, in general you want implied volatility to go down. That’s because it will decrease the value of the two options you sold more than the single option you bought.

The closer the stock price is to strike B, the more you want implied volatility to decrease for two reasons. First, it will decrease the value of the near-the-money options you sold at strike B more than the in-the-money option you bought at strike A. Second, it suggests a decreased probability of a wide price swing, whereas you want the stock price to remain stable at or around strike B and finish there at expiration.

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