The trade itself involves selling a call (or calls) at a lower strike and buying a greater number of calls at a higher strike price. Ideally, this trade is initiated for a minimal debit or possibly a small credit. This way, if the stock heads south, you won't suffer much either way. On the other hand, if the stock takes off, the profit potential will be unlimited because you have more long than short calls. To maximize the potential for this position, many traders use in-the-money options because they have a higher likelihood of finishing in-the-money.
Using International Paper (IP), a company that historically has been quite volatile, we can create a ratio back spread using in-the-money options.
In this case, you might buy two of the JUL 45 calls at $1.05 and sell one 40 call at $4.00.
To see how this works, consider the following:
|IP trading @ $43.46|
|Buy 2 IP JUL 45 Call @ $1.05||$210.00|
|Sell 1 IP JUL 40 Call @ $4.00||($400.00)|
|Credit from Trade||($190.00)|
In this case, you would receive $190 ((4.00 - 2.10) x 100 shares) for putting on the trade. If the stock dropped below $40, you would keep the $190. However, the real money would be made if the stock made a huge move to the upside. The upside breakeven for this trade would be $48.10. At this price, the 40 calls would be worth $8.10 (8.10 x 1) each while the 45 calls would be worth $6.20 (3.10x2). Factoring in the initial $190 credit, the ROI at this price would be 0. Above $48.10, the profit potential is unlimited.
Calculating the Breakeven
The easiest way to calculate the upside breakeven is by using the following formula:
Upside Breakeven = Long strike price + [(Long strike - short strike) x # of short contracts] - net credit/100*
*(or + net debit)
Using the data for this example, the breakeven calculation looks like this:
45 + [(45 - 40) x 1] - 190/100
The maximum loss for this trade would occur with the stock at 45 because the long calls would be worthless and the short call would be worth $5. Factoring in the initial credit of $190, the maximum loss on this trade would be $310 (1 contact x $5 x 100 shares - $190 credit).