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 Strike Price?40 Views
Finance a la shmoop what is a strike price well before going
even a second further with this video be sure you've seen our Steven Spielberg [Introduction to a movie at the cinema directed by Steven Spielberg]
directed what is a stock option video here are the reviews from variety.. well
to review a stock option is the right to buy a share of stock for a set price
over a given period of time so let's say you were granted an option to buy a [Graph of amazon stock prices]
share of Amazon stock in 2015 when the stock was around 400 bucks a share the
option lasts as long as you work at the company in good standing or after 10
years have passed which ever ends first well one day you decide you want another job [Woman signing a contract]
your contract says that if you're no longer an employee with the company then
you have 90 days in which to either buy out your option that is to buy the
option and then own the stock or just forfeit the option [Woman underlining words on a contract]
well since Amazon is now at a thousand bucks a share you obviously don't want
to forfeit the option to buy that share of stock for 400 bucks but you note that
your many friends who joined apcray.com at a high price a high strike price which
creators know they're stock while they're doing a lot of option forfeiting
that is their options ended up being worthless so you've got a lot to think [Man holding out a bag of dog poo]
about here this is Amazon not apcray so you want to buy out your option so
what happens well you were granted your own options at the price Amazon stock [Amazon box falls off shelf]
was trading at the day you joined the company it was 400 bucks a share so
that's a strike price that $400 is the price you pay to buy a share of stock at
some point there in the future that strike price has nothing to do with [Protestors holding signs outside an Amazon building]
unions not working got it? all right well in order to buy that stock it's
currently trading in a thousand bucks a share
you pay Amazon 400 bucks and that buys out your option you then own the stock [Man writing a check to Amazon for 400 dollars]
that's it Amazon cancel your option then they give
you a share of actual stock which you now own for as long as you want to own [Man delivering an Amazon box]
it you can sell it immediately and make a
$600 a share profit that's a thousand bucks a share it's trading at now minus the
$400 strike price you just paid to buy out that option got it or you can hold [Grandparent bribing grand-daughter for amazon stock]
onto those shares and you know use it to bribe your grandchildren one day it's
worth like a million dollars a share
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