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Ratio Call Spread

Options Strategy - Ratio Call Spread

Description

This is a useful strategy for a stock investor who wants to start to accumulate a position in XYZ at current levels. For example, an investor thinks that XYZ is "bottoming" and wants to buy 200 shares. Although confident, the investor wants to only buy 1/2 now in case XYZ moves lower.

When to use

Even though it contain only 1/2 of the 200 XYZ shares that the investor wishes to accumulate, it is important to remember the downside risks inherent in any stock position. Usually, the options are selected so that the Call Spread is established for a small debit or even a credit (buying 1, writing 2).

Risk/Reward Characteristics

The spread's maximum profit potential is reached at or above the striking price of the written Calls (65) at expiration. Because stock investor ownership exists, the downside risk can be large if XYZ has a large decline. Depending on the initial price of the Call spread, this strategy's P&L can approach that of a 200 share position if XYZ is at $65 at expiration! Thus, the investor can have nearly the same profit at $65 with only 100 shares!

Break-even Point: Stock Price + spread debit (or minus spread credit).

Time Decay: If XYZ is near the strike price of the two written Calls (65), profits from decay accelerate most rapidly over time. If XYZ stays near $60, profits from decay of the 65 Calls offset loses on the 60 Call. As expiration approaches, the spread's price becomes mostly a function of the price of the 60 Call.

Volatility: An increase in volatility is a negative. The impact will depend of time left until expiration and the price of XYZ relative to the two strike prices. Because of this, it is important that the implied volatilities of XYZ's options be high enough to allow the spread to be established for near zero.

Assignment Risk: The investor must continuously monitor XYZ for possible assignment if the 65 Calls become in-the-money prior to their expiration.

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