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 Call Option?25 Views
finance a la shmoop. what is a call option? option? option, where are you? okay
yeah yeah. not phone options, call options. and a close but no cigar. a call option [man smokes in a tub of cash]
is the right to call or buy a security. the concept is easy the math is hard.
you think Coca Cola's poised for a breakout as they go into the new low
calorie beverage business. their stock is at 50 bucks a share and you can buy a [man stands on a stage as crowd cheers]
call option for $1. well that call option buys you the right
to then buy coke stock at 55 bucks a share anytime you want in the next
hundred and 20 days. so let's say Coke announces its new sugarless drink flavor
zero it's two weeks later and the stock skyrockets to fifty eight dollars a
share. you've already paid the dollar for the option now you have to exercise it. [man lifts weights]
so you buy the stock and you're all in now for fifty five dollars plus one or
fifty six bucks a share and your total value is now fifty eight bucks. well you
could turn around today and sell the bundle that moment, and you'll have
turned your dollar into two dollars of profit really fast. and obviously had the [equation on screen]
stock not skyrocketed so quickly well you would have lost everything. still you
lucked out and now you're sitting on some serious cash, courtesy of your call [two men in a tub of cash]
options. as for Coke flavor zero turned out to be nothing more than canned water.
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