Potential goals
To profit from a stock price move to the strike price of the short calls with limited downside risk.
Explanation
A 1x2 ratio vertical spread with calls is created by buying one lower-strike call and selling two higher-strike calls. The second short call is uncovered (naked) and has unlimited risk. This strategy can be established for either a net debit (as seen in the example) or for a net credit, depending on the time to expiration, the percentage distance between the strike prices and the level of volatility. Profit potential is limited, and the maximum profit is realized if the stock price is at the strike price of the short calls at expiration. Above the breakeven point risk is unlimited, because the stock price can rise indefinitely.
Example of 1x2 ratio vertical spread with calls
Buy 1 XYZ 100 call at 3.30 |
Sell 2 XYZ 105 calls at 1.50 each |
Maximum profit
If the position is created for a net debit (cost), profit potential is limited to the difference between the strike prices minus the net debit including commissions. In the example above, the maximum profit is 4.70, because the higher strike price minus the lower strike price is 5.00 (105.00 – 100.00) and the net debit is 0.30. Therefore, 5.00 – 0.30 = 4.70.
If the position is created for a net credit (amount received), profit potential is limited to the difference between the strike prices plus the net credit less commissions. If the position had been established for net credit of 50 cents (0.50), the maximum profit would be 5.50, because the higher strike price minus the lower strike price is 5.00 (105.00 – 100.00) and the net credit would have been 0.50. Therefore, 5.00 + 0.50 = 5.50.
Maximum risk
On the upside, risk is unlimited, because the position has an uncovered short call (naked call), and the stock price can rise indefinitely.
On the downside, potential risk depends on whether the position is established for a net debit or a net credit. If established for a net debit, the maximum risk is equal to the net debit including commissions. If established for a net credit including commissions, there is no downside risk. If the stock price is below the lower strike price at expiration, then all calls expire worthless and the net credit is kept as a profit.
Breakeven stock price at expiration
If the position is established for a net debit, there are two breakeven points: Lower breakeven point: Lower strike price plus the net debit In this example: 100.00 + 0.30 = 100.30 Higher breakeven point: Higher strike price plus the maximum profit In this example: 105.00 + 4.70 = 109.70
If the position is established for a net credit, there is one breakeven point: Assuming the position is established for a net credit of 50 cents (0.50): Breakeven point: Higher strike price plus the maximum profit In this example: 105.00 + 5.50 = 110.50
Note: If this position is established for a net credit, there is no “lower breakeven point.” If the stock price is below the lower strike price at expiration, then all calls expire worthless, and the net credit is kept as profit.
Profit/Loss diagram and table: 1x2 ratio vertical spread with calls
Buy 1 XYZ 100 call at 3.30 |
Sell 2 XYZ 105 calls at 1.50 each |
Stock Price at Expiration | Long 1 100 Call Profit/(Loss) at Expiration | Short 2 105 Calls Profit/(Loss) at Expiration | Net Profit/(Loss) at Expiration |
---|---|---|---|
113 | +9.70 | (13.00) | (3.30) |
112 | +8.70 | (11.00) | (2.30) |
111 | +7.70 | (9.00) | (1.30) |
110 | +6.70 | (7.00) | (0.30) |
109 | +5.70 | (5.00) | +0.70 |
108 | +4.70 | (3.00) | +1.70 |
107 | +3.70 | (1.00) | +2.70 |
106 | +2.70 | +1.00 | +3.70 |
105 | +1.70 | +3.00 | +4.70 |
104 | +0.70 | +3.00 | +3.70 |
103 | (0.30) | +3.00 | +2.70 |
102 | (1.30) | +3.00 | +1.70 |
101 | (2.30) | +3.00 | +0.70 |
100 | (3.30) | +3.00 | (0.30) |
99 | (3.30) | +3.00 | (0.30) |
98 | (3.30) | +3.00 | (0.30) |
97 | (3.30) | +3.00 | (0.30) |
Appropriate market forecast
A 1x2 ratio vertical spread with calls realizes its maximum profit if the stock price is at the strike price of the short calls at expiration. The forecast, therefore, can either be “neutral” or “modestly bullish,” depending on the relationship of the stock price to the strike prices of the calls when the position is established.
If the stock price is at or near the strike price of the short calls when the position is established, then the forecast must be for continued stock price action near the strike price of the short calls (neutral).
If the stock price is below the strike price of the short calls, and possibly below the strike price of the long call, when the position is established, then the forecast must be for the stock price to rise to the strike price of the short calls at expiration (modestly bullish).
While one can imagine a scenario in which the stock price is above the strike price of the short calls and in which a 1x2 ratio vertical spread with calls would profit from bearish price action, it is most likely that another strategy would be a more profitable choice for a bearish forecast.
Strategy discussion
A 1x2 ratio vertical spread with calls is the same as buying a bull call spread and simultaneously selling an uncovered (naked) call. The premium from the uncovered call is used to at least partially pay for the bull call spread. The position profits from time decay as the underlying stock trades near the strike price of the short calls. While the “low” net cost to establish the strategy – or possible net credit – is viewed as an attractive feature by some traders, the strategy has unlimited risk from the uncovered call. There is also a margin requirement for the uncovered call in additional to the up-front cash requirement for the bull call spread. This strategy, therefore, is suitable only for experienced traders who are suited to accept the unlimited risk.
Choosing a 1x2 ratio vertical spread with calls requires both a high tolerance for risk and trading discipline. A high tolerance for risk is required, because potential risk is unlimited on the upside. Trading discipline is required because the ability to “cut losses short” is an attribute of trading discipline. Many traders who use this strategy have strict guidelines – which they adhere to – about closing positions when the market goes against the forecast.
Impact of stock price change
“Delta” estimates how much a position will change in price as the stock price changes. Long calls have positive deltas, and short calls have negative deltas. The net delta of a 1x2 ratio vertical spread with calls varies from +1.00 to −1.00, depending on the relationship of the stock price to the strike prices of the options.
The position delta approaches +1.00 if the long call is in the money and the short calls are out of the money as expiration approaches. In this case, the delta of the long call approaches +1.00, and the deltas of the short calls approach zero.
When the stock price is above the strike price of the short calls as expiration approaches, the position delta approaches −1.00, because the delta of the long call approaches +1.00 and the deltas of the two short calls approach −1.00 each.
The position delta approaches zero as the stock price falls below the strike price of the long call, because the deltas of all the calls approach zero.
Impact of change in volatility
Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. Long options, therefore, rise in price and make money when volatility rises, and short options rise in price and lose money when volatility rises. When volatility falls, the opposite happens; long options lose money and short options make money. “Vega” is a measure of how much changing volatility affects the net price of a position.
Since a 1x2 ratio vertical spread with calls has one long call and two short calls, rising volatility generally hurts the position and falling volatility generally helps. In the language of options, this is “net negative vega.” As expiration approaches, however, the impact of changing volatility depends on the relationship of the stock price to the strike prices of the options. If the stock price is close to the strike price of the long call, then the net vega tends to be positive. If the stock price is close to the strike price of the short calls, then the net vega tends to be negative. The net vega approaches zero if the stock price falls below the lower strike or rises sharply above the higher strike.
Impact of time
The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion. “Theta” is a measure of how much time erosion affects the net price of a position. Long option positions have negative theta, which means they lose money from time erosion, if other factors remain constant; and short options have positive theta, which means they make money from time erosion.
Since a 1x2 ratio vertical spread with calls has one long call and two short calls, the impact of time erosion is generally positive. In the language of options, this is a “net positive theta.” As expiration approaches, however, the impact of time erosion depends on the relationship of the stock price to the strike prices of the options. If the stock price is close to the strike price of the long call, then the net theta tends to be negative and time erosion hurts the position. If the stock price is close to the strike price of the short calls, then the net theta tends to be positive and time erosion benefits the position.
Risk of early assignment
Stock options in the United States can be exercised on any business day, and holders of short stock option positions have no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options.
While the long call in 1x2 ratio vertical spread with calls has no risk of early assignment, the short calls do have such risk. Early assignment of stock options is generally related to dividends, and short calls that are assigned early are generally assigned on the day before the ex-dividend date. In-the-money calls whose time value is less than the dividend have a high likelihood of being assigned.
If assignment is deemed likely, there are three possibilities. First, one of the two short calls is assigned. In this case, 100 shares of stock are sold short and the long call and the second short call remain open. Second, both of the short calls are assigned. In this case, 200 shares are sold short and the long call remains open. Third, neither call is assigned. No matter how likely assignment may seem, there is no assurance that it will occur. In this case the 1x2 ratio vertical spread with calls remains intact.
If early assignment of one or both calls does occur, stock is sold, and a short stock position of 100 shares or 200 shares is created. If a short stock position is not wanted, 100 shares can be closed by exercising the long call, but the second 100 shares must be purchased in the marketplace. Note, however, that whichever method is used, the date of the stock purchase will be one day later than the date of the short sale. This difference will result in additional fees, including interest charges and commissions. Assignment of a short call might also trigger a margin call if there is not sufficient account equity to support the short stock position.
Potential position created at expiration
The position at expiration depends on the relationship of the stock price to the strike prices. If the stock price is at or below the strike price of the long call (lower strike), then all calls expire worthless and there is no stock position.
If the stock price is above the lower strike but not above the higher strike, then the long call is exercised and the short calls expire. Exercising a long call causes stock to be purchased at the strike price, so the result is a long stock position. Since long options are exercised at expiration if they are one cent (0.01) in the money, if long shares are not wanted, the long call must be sold prior to expiration.
If the stock price is above the higher strike price then the long call is exercised and both short calls are assigned. In the example above, this means that 100 shares are purchased and 200 shares are sold. The result is a position of short 100 shares. If the stock price is above the higher strike immediately prior to expiration, and if a position of short 100 shares is not wanted, then one of the short calls must be closed.
Other considerations
In a “ratio spread” there is a difference between the number of options purchased and the number of options sold. The term “vertical” in the name of this strategy implies that more options are sold than purchased. In contrast, in the “1x2 ratio volatility spread with calls,” the term “volatility” implies that more options are purchased than sold.
This strategy – the 1x2 ratio vertical spread with calls – is also known as a “front spread,” because it is generally used with short-term, or “front-month,” options as opposed to longer-term, or “back-month,” options. Shorter-term options are more suitable for this strategy, because this strategy profits mostly from time decay when the short calls are at the money and close to expiration. At-the-money short-term options experience a greater rate of time decay than longer-term options.