To define the essence of a trading strategy known as a call ratio backspread, it helps to understand basic options. Yes, duh.
There are call options (when long, they're a bet that the price of an asset will go up) and put options (a bet that the price will go down). The buyer of an option has the right, but not the obligation, to buy the underlying asset (such as a stock) at a particular price by a certain date. In a call ratio backspread an investor wants to both hedge against possible losses if the stock price goes down and maximize his profit if stock prices goes up.
Barry Backspread likes what he is hearing about the mattress industry and wants to invest in these companies. He also would like to purchase more shares than he has the cash on hand for. But since competition is increasing in the mattress industry, Barry also worries that he could be wrong. So he wants to cover himself for either scenario.
His first step is to sell 100 call options of Comfort Mattress Inc. with a strike price (what price the buyer will pay for the stock) of $6 per share. These are his "short" calls. Comfort Mattress stock is currently hot, so he receives $20,000 for selling those options. Barry uses that money to buy 200 call options with a strike price of $12 per share in a smaller company, Mattress in a Box. This would be a "long call." He was able to buy twice as many call options for the smaller Mattress in a Box. If stock prices do go up, Barry will make a profit from owning the options to buy Mattress in a Box at $12 a share. He will not be so lucky with Comfort Mattress because the strike price is up, but since he owns twice as many shares in Mattress in a Box he still has a net gain.
If prices go down on both companies, he loses out on the opportunity to make money since the options will expire as worthless, but he doesn't lose anything. A call ratio backspread only works when stock prices are going up and you don't want to bet the farm as you're hedged in a sense from both directions.
Related or Semi-related Video
Finance: What Is a Put Option?83 Views
finance a la shmoop what is a put option? hot potato hot potato
ow ow! yeah remember that game well nobody wanted the potato, poor thing. the
players wanted to put it in someone else's hands. well put options kind [glue put around a flaming potato]
of work the same way. a put option is the right or option or choice to sell a
stock or a bond at a given price to someone by a certain end date.
all right example time. you bought netflix stock at the IPO a zillion years
ago at $1 a share. that's you know splits adjusted. all right now it's a hundred
bucks a share. if you sell it you pay taxes on a gain of 99 dollars a share. in
California that would be a tax of something like almost 40 bucks. well the
stock was a hundred but you keep only something like 60. feels totally unfair.
right so you really don't want to sell your stock but you're nervous about the [graph shown]
next few months that Netflix will crater for a while and go down ten
maybe twenty dollars. longer term though you think it'll hit 300. so this is the
perfect setup to maybe look at buying some put options on Netflix. if the stock
goes down your put options go up. with Netflix volatile but at a hundred bucks
a share ,you look up the price of an $80 strike price put option expiring in
December, and you know that's mid-september now .for five bucks a share
you can protect your stock for the next few months .think about it like temporary [stocks placed in vault]
term life insurance. you pay the five dollars a share in the stock goes down
to 82 by mid December, worst of all worlds. well not only did you lose the $5
a share but your stock has lost $18 in value. but had Netflix really cratered
and gone to say $60 a share well you would have exercised your put and sold
your shares at 80 bucks. well those put options you paid $5 for
would be been worth 15 bucks a share. in buying that put option you've [equation shown]
guaranteed that your loss will be no more than a $75 value for your Netflix
position at least for that time period and ignoring taxes. well remember that
options expire after December whatever like the third Friday of the month it's
usually when options expire, you then have no protection and your shares float
along naked. naked? really who knew accounting could get so [paper put option goes "skinny dipping".]
raunchy. yeah well that's naked put options.
that's what they really are people.
Up Next
What is a call option? A call option is a type of contract that lets the investor buy shares of a stock at a certain price and within a window of t...
What is a strike price? Strike prices are used in conjunction with options. Calls and puts give investors the right to buy or sell stocks at predet...