Back Ratio Spreads Explained

The Back Ratio provides excellent risk management and is good to trade when you have a directional bias on the stock but want to protect yourself in case the stock does not behave as you had expected. This makes the Back Ratio a good trade before earnings' announcements or other significant news events.

Basic transaction:
If you are bullish on the stock.
Sell lower strike call
Buy higher strike call
Where you buy more calls than you sell. The usual ratios (thus the name back ratio spread) are 2:1, 3:2, 5:3. For instance buy 2 calls and sell 1.
Both for same expiration, preferably 2-3 months out.
This trade is shown below in the risk profile graph.

OR
If you are bearish on the stock.
Sell higher strike put
Buy lower strike put
Where you buy more puts than you sell. The usual ratios (thus the name back ratio spread) are 2:1, 3:2, 5:3. For instance buy 2 puts and sell 1.
Both for same expiration, preferably 2-3 months out.
The risk profile will the similar but opposite to the risk profile below.

Risk Profile:

Current price for BAC is 16.90.
Sell 1x 17.5 calls for .95/contract
Buy 2x 19 calls for .47/contract
Total net CREDIT .01/2:1 ratio.


Strategy:
The first thing to realize for this trade is that we have a net credit. This means you GET .01/spread. This does not necessarily happen every time. It is just as easy to find net debit spreads or net credit spreads where the credit is pretty significant- it really all just depends on the implied volatility of the options. Keep in mind that if you have a huge net credit spread, it means that the demand of your short option is much bigger than your long option. This could mean that you may have missed something in your analysis and need to figure out why the demand of the short option is so high.

Secondly, a back ratio is something you never keep till expiry (unless you have a net credit and the stock goes way south of where you had expected it to go). So, in my explanation below, I will assume that we will trade away this back ratio after 3 weeks.

You bias on a call back ratio is bullish and a put back ratio is bearish. The basic reasoning for trading a back ratio is that it reduces your cash outlay, and as seen above, can in fact create a credit trade. Back ratio also significantly reduces your risk if your hypothesis is wrong and the stock moves the other way. All these are explained below in more detail.

But first, I will illustrate what would happen if you simply bought a call contract. If you bought a Nov call contract for strike 19, your cash outlay would be $.47/contract. Your max loss, after 3 weeks, of $.47/contract is highly unlikely. A more likely scenario is a support level your identify. Assume this support level is $15, at which point your loss is .33/contract, or about 70%.

Your max profit is infinite if BAC rises forever. Your infinite profit scenario is highly unlikely. What is more likely is that you will identify some resistance/target level that you expect the BAC to reach. Let's say this target is $20. At $20, your profit (in 3 weeks) is 1.26/contract. That is a ROI of 268% (Woah!) when the stock moved 18%. That is pretty awesome.

How does the Back Ratio compare to simply a long option. First of all, you have a net credit so you cannot use a ROI to figure out your return. Instead, I use return on margin requirement, which is $1.46/spread. Max loss, after 3 weeks, in this case is around .09/spread, which you get at $16.70. At ALL other price levels, your loss is less than .09/spread, or about 6%.

Your max profit is infinite, but highly unlikely. Assuming the resistance level of $20, your profit at $20 is .66/spread. That is a return on margin req. of ~45%.

Reduced Cash Investment
As is clear, the cash investment for a Back Ratio is significantly lower than for a simple long option. On the other hand, the margin requirement is much higher. However, if you have a broker that will let you reduce margin requirements (because you will never reach that max loss level), you might be able to leverage that and use those funds for other investments.

Reduced Risk
The max loss for a long option, based on the scenarios described above, is around 33%. Compare that to a mere 6% max loss scenario for the Back Ratio. Also, remember that the 6% loss is only possible at a single price level, which is unlikely. What is more likely is that with the Back Ratio your max loss exposure is much lower than 6%.

Potential Return on max loss: 1.26/.33= 318%
Potential Return on max loss: .66/.09 = 733%

Volatility Play
Another important aspect of the Back Ratio is the importance of implied volatility in this strategy. The biggest take-away is that if the implied volatility of the options rises, your position, payoffs, and risk exposure improve significantly. If it falls, you are much worse off.

Entire books have been written on this subject so I will not go into more detail on this subject in this post.


In conclusion, the Back Ratio is an excellent choice when trading an underlying which could move either way. You clearly have a directional bias and anticipate the stock to move one way, but you are not exposed if the stock does not behave as you had anticipated.