What is a Ratio Backspread?

A ratio backspread can be used with calls or puts depending on the directional bias a trader has but for the purposes of this write up I will use the call backspread as an example. A call ratio backspread is an advanced options strategy that is best used in a volatile market in which a trader believes the stock will rise sharply in a short amount of time. The strategy involves combining one short call with two long calls further out-of-the-money in the same expiration date. The appeal to this is that it can often be done for a small debit or even a credit which protects the downside risk if the stock or market keeps falling fast. On the flip side, the gains can be significant if the stock rallies higher in a fast way since the ratio spread is long gamma or long more options than it is short. These spreads are usually done using a 1×2 structure but can also be 1×3 or 2×3 depending on the setup and overall assumption the trader has. In a volatile market, these can pay off nicely as realized volatility often is high enough to justify the potential movement and since it’s usually a small debit being risked, the downside is largely limited. 

Key Dynamics of the Ratio Backspread

A call ratio backspread is used when bullish and is created by selling one call option near the current stock price and using that credit collected to buy a larger number of calls at a higher strike price. The spread has unlimited upside since you would be long more calls than you are short. If you pick your strikes to create a net credit then there is zero downside risk on the trade and actually it may make a small profit if the underlying stock continues to fall drastically.  So what’s the catch?

This spread is essentially looking for a big move fairly quickly and the main greek exposure is long delta and gamma, while being negatively impacted by theta and vega. So timing is important because time decay and implied volatility contraction can be the enemy here if the stock does not move sharply enough. The main risk to the backspread is the stock trading sideways between your strike prices and that “valley of death” on the risk graph below shows why. If the stock stays stable the time decay or extrinsic value from the long options works against you while the short option retains its intrinsic value, exactly what you don’t want when looking for a large directional move. 

Part of the benefit of using a backspread during higher volatility times in the market is the fact you are selling a juicy option with high IV to finance the purchase of your long gamma component, the two long calls. The premiums in high volatility markets can often be much too high to just buy a long call since IV gets crushed on an oversold rally generally so using a spread that pays for the long calls is a way to offset that. The offset in premiums can be partially offset or the credit collected can fully pay for the long options you buy. 

The SPY call ratio backspread below shows the profit and loss potential. Sort of a hockey stick pattern. This example with the SPY at 400 and using May 20th expiration with 10 days left. Selling one 400 call and buying two 410 calls can be done for a net credit of about $0.33. There is a margin requirement since you are selling a closer to the money option but for this example its just $1000 per spread minus the credit received. This means if the market crashes you still make $33 per spread. Not too shabby for being bullish. But if the surge higher you expect plays out fast enough then you stand to make a solid return if SPY gets up to 410 or higher. Velocity is the key here, the faster the better. Since the main risk is if nothing at all happens it’s good to trade these with smaller sizes. Each day that passes without a big move higher the pink line will move towards the blue expiration line and the “valley of death” zone sagging lower between 400-410 becomes your risk. This is why I would not hold these anywhere close to expiration. If bought at 10 days till expiration, you ideally want to exit in 1-3 days or less.

When to Use Ratio Backspreads

This is not a strategy I use often but lately in these volatile markets it’s been a nice option to have when trading trend reversals or large moves in the market. The goal overall for the stock is to rise fast and above the long call strike price. Say the market has been selling off for 3-4 days and you think there is potential for a short covering rebound the screams higher off a support level or short term capitulation is being seen. Since we know markets usually bounce very hard in downtrends or bear markets the ratio backspread sets up nicely for this as it exposes the trader to long gamma upside while limited downside if the market continues to crash lower. The key thing is you want to use this strategy when things are moving. Objects in motion tend to stay in motion. That is definitely true in volatile markets. It doesn’t usually just change overnight. If the SPY is at 400 and daily implied moves are around 5 points then it’s unlikely the SPY just stays near 400 for too long. It’s likely going to be at 390 or 410 sooner than later. Call ratio backspreads are designed to benefit from these increases in market volatility. 

When selecting strikes and expirations it comes down to your assumption. I will usually trade these short term so a near term weekly expiration tends to offer the more bang for your buck, or gamma potential. It’s either going to work in a few days or I’ll get out. These are not trades you want to give much patience since it’s often a race against time and volatility. The closer you wait until expiration the more risk you take on. Selecting the at-the-money strike to sell and then buying the strike further out where you envision price to go is a good rule of thumb but even using something like the 30 delta strike to buy is fine. 

Example of a Call Ratio Backspread in TSLA

A recent backspread I traded was with Tesla (TSLA) after a steep selloff it had. In about one week TSLA fell from 1075 to near 850 after their earnings report and news of Elon Musk buying TWTR which sparked fears he would sell more TSLA. After about 5 days of selling like the chart below shows, it seemed like a time for a rebound so on 4/28 I decided to play a potential bounce with a short term call ratio backspread. With the stock near 840 I opened the 840/865 call backspread for a credit for $-2.39. If TSLA kept falling I wouldn’t lose money. How cool. I just needed it to move sharply higher by the end of the week, ideally that day. In less than two hours it did just that, rising from 840 to over 890. I think I exited around 875 however for a respectable price of 4.70. Taking in the $2.39 credit to open plus then selling it out for $4.70 means the profit was a total of $709. In hindsight it could have been sold for much higher, I later saw the price near $12.00 but taking the quick win on these once you get a sharp move is the goal since time is the enemy.

Takeaways: 

• A call ratio backspread is a bullish options strategy that buys calls and then sells a call of a different strike price but same expiration on a ratio of 1×2 generally. 
• The backspread has more long calls than short calls which allows for unlimited upside potential.
• A call backspread limits downside losses since the short call is financing the long calls. If put on for a credit there is no downside risk.
• This strategy performs best in higher volatility markets where realized price movement is exceeding what is expected or implied by the options markets.