Beginner's Guide to Trading Call Ratio Backspreads | Selecting an Option Strategy
[Music] [Music] good morning and welcome everyone my name is cameron may it is 9 30 eastern standard time on a thursday morning that means it's time to get back to our ongoing weekly series of discussions called selecting an option strategy and today we're going to be doing a strategy is a bit of a mouthful for some it's known as a call ratio back spread we're going to be weighing the pros and the cons of selecting that as the strategy of the day so i'm looking forward to it let me as we get deeper into this discussion we'll be setting more precise agenda for that uh for that topic but before we do that let me say first of all hello to everybody that's chatting in from all around the country hello there wayne and vijay ap514 crispy heart man uh boss jenkins saul anthony david robert bonnie joe and on and on that list goes definitely appreciate your attendance your ongoing contributions to these discussions if you're here for the very first time though i want to welcome you as well if you'd like to chat in let me know this your first time on my webcast i do always like to see who my new audience members are and if you're watching on the archive after the fact enjoy the presentation but be aware that you're invited to join us in the live discussion kicks off promptly opening bell thursday mornings and this one runs about 30 minutes so you don't want to be late to this one and as a final heads up my very good friend barb armstrong is going to be hanging out in the chats with you answering any questions that that i can't address during the natural blow over the presentation she's fantastic resource to have here so thanks barb for having my back but let's get right into it very first thing that i want to do is to give you an invitation if you're not following me and barb on twitter please do barb's twitter handle is at b armstrong underscore tda mine is at c may underscore tda and that is the very best place to have that more personalized ongoing interaction with your favorite instructors we also need to bear in mind the risks associated with investing this is important information so please do keep it in mind the content we're about to provide is intended for educational or informational purposes only options are not suitable for all investors there's a special risk inherent to options trading may expose investors potentially wrap up in substantial losses having success with your real funds is not a guarantee that you're going to have pardon me having success with your paper money account is not a guarantee that you're going to have success with your real funds as market conditions do change and they can change rapidly while this webcast discusses technical analysis other approaches including fundamental analysis may assert very different views and finally all investing involves risks including the risk of loss all right so here's the agenda for the day as it is each week now i'm going to mix things up a little bit first thing on the on the agenda is typically to ask ourselves three questions and then we're going to dive straight into a market review typically to pursue the answers to those questions now these first two pieces of the agenda i'm going to kind of blast through this normally i might spend 10 minutes going through it a little a little bit slower pace today i want to give as much time as possible to the topic at hand because this is going to be new for a lot of you matter of fact if you wouldn't mind letting me know just chat in let me know how comfortable or would you say yes you're you're familiar with and comfortable with a call ratio back spread strategy or no it's mostly new to you yeah so we're going to spend the bulk of our time on the strategy and we're going to place an example paper money trade before we're done today so that we we get to discuss not only the theory of investing but also the application all right so let's go right to thinkorswim it looks like uh yeah we're having some yeses there's a never heard of it michael's saying nope this is new to me says charles that's what i suspected yep so let's make sure that we give as much time as we can to the strategy it doesn't mean it's a sales pitch for the strategy and i'm gonna let me let me lead into this discussion with this uh observation about strategy sometimes things can sound complicated with options today we are dealing exclusively with call options so as long as we understand how calls work i would say you are a big stride forward to fully understanding this strategy okay but here are our typical clarifying questions are we looking at bullish bearish and neutral market conditions is it more of a buyer's market or more of a seller's market for options and are we looking for higher probability uh trade or higher reward potential from our trade so let's just very quickly address these let's take a quick peek at the s p 500 let's suppose for better for worse right or wrong an investor looks the s p and they see boy we may be making higher highs and higher lows it's been a pretty good summer so far a nice start to the last six months of 2022 and they suspect that that's likely to continue maybe this is just another bull flag as we've pulled back for the last couple of days and so their outlook for their next trade is bullish all right well that narrows the field of potential options strategy candidates pretty dramatically now they look at market conditions for options and they say boy it seems like volatility has fallen quite a bit and we've come down near six month lows so maybe this is a good opportunity to be a buyer of options rather than a seller of options now some of you are going to look at this little rundown that i just did and say cameron i don't so not what my convictions are about the markets that's okay we're just setting a theoretical stage for an educational discussion of a strategy that would fit these conditions when the investor holds those uh those opinions about the markets right now finally let's say the investors looked at their portfolio they do a little personal inventory and they say you know what i'm ready to take a little bit greater risk on this trade so rather than focusing on on probability we're going for reward so for today's discussion we're going for a bullish trade that's built primarily around buying options with a high reward potential not a high probability of success necessarily but it is a strategy i'll tell you a little t a little uh spoiler alert this is a strategy with unlimited reward potential okay all right so let's get uh and jack that's a good discussion maybe jack um i'll maybe set that aside as a as a potential video for a future discussion because whenever we're comparing two different strategies i like to give them both uh a good examination so i'll park that in the ideas column for now is that okay but let's say since we're looking for bullish trades let's pop over here let's see what's happening with google i don't know if you've been following what's been happening with google's been back and forth in a 15 range for about two months and it seems like it may be breaking the upside it's settling right in top side of the previous channel so if that was a 15 wide channel for some technicians they might think well now we're sitting up here at around 119 maybe that projects a move to the upside around 134 135. another 15 dollars to the upside all right so let's say that the expectation for that trader is for prices to go up and maybe sharply because if you look at the way google has a tendency to move once it makes up its mind it tends to cover a lot of territory pretty quickly a week or two it can be 15 percent up or down 15 up or down on basically a 100 do a little bit of rounding here for convenience purposes but basically about a 15 percent move very quickly so let's say the investor has the opinion and obviously only time will tell if it proves to be right that google is ready to go up so they start to build for themselves a trade idea and this is gonna be our example trade and as as i mentioned it's called a call ratio back spread has a bit of a lengthy name a little bit of a mouthful but and wayne you like this this is a good topic okay or maybe you're talking about jack having a better idea for a topic where i do comparison anyway let's uh let's go build a trade we're gonna go to the trade tab and really if we're bullish we want to buy some options with a with a high reward potential couldn't we just buy some calls so let's actually push this out and also notice in the chat somebody asked isn't it about time to start pushing out to october when might we do that well when the trader thinks they need more time on the contract and the other the other contracts are getting closer to expiration yep it's probably time to start move out moving out to a more distant expirations so how about we go out here to the 21st of october contracts i'm going to still stick with those third friday expiration contracts they tend to have more liquidity than the weeklies but let's say we go out here and with the stock trading around 120 what if we go to let's say let's go to the 125. and we buy as an example let's buy two and you'll understand why i'm going with two legislation okay but we're going to buy two of the 21st of october 125 calls and it looks like those are trading between 3 345 and 350 let's just call it 350. okay
3.50 per share these are standard contracts so they're it's a per share basis on 100 shares spending 350 per contract at 700 um expense for the trade right so could we just stop right there and have we checked all of the boxes for buying or entering into a strategy selecting a strategy that fits all of our requirements could stop right there but for some investors or some traders they look at this and say well geez few problems with this trade number one it's kind of pricey number two has time decay exposure number three if i'm wrong and the stock goes down rather than up i could really get punished here is there some way to potentially address all three of those scenarios and yes there is with its own attendant risks right we have to examine the pros and cons of what we're doing of each strategy but yes we could actually turn this in return this from just being two long call options just buying two options we're going to turn this into a call ratio back spread so here's what here's what we're going to do at the same time we buy those two long options we're going to sell one call option same sock same expiration different strike let's stay here in october and we've gone out of the money for our two long options now we're actually going to go closer or actually go for a more expensive option let's go up here to maybe the 117 and a half this is interesting that 117 and a half call is trading right now for between 720 735 let's say we can get what do we call 725 725 for that call all right so what what do we what do you immediately see that we've done with this trade well we spent seven bucks per share well we spent 350 per share on 200 shares or 700 to buy two call contracts and then we just brought in 725 dollars from selling a call option all right so this actually generates a net credit not always i will say these ratio spreads are not always done for a credit you know had we done one at a slightly higher strike it would have actually generated a small debit right but in this case it generates a credit of 25 cents per share right or 25 let's just put it bottom line 25 bucks is what we're getting paid so yeah charles we turned that debit into a small credit that was the obvious thing well what is it also done um for time decay and for and this is maybe the biggest one what about that downside risk on the trade well time decay negatively impacts buyers of options it positively impacts sellers of options and this is pretty much going to be a wash if we were to pop up here let's change our net change column let's go to our theoreticals and greeks and change that to theta so that we can we can see our theta our 125 calls negative four that's times two so it's we're losing eight cents on basically if everything else held constant eight eight cents of time decay per day the 117 call positive 5 cents so we've just washed out a lot of that time decay haven't eliminated it but we've reduced it substantially that's interesting but i think far more interestingly is how this changes the consequences for price moves on the stock let's talk this through let's go to our chart and i want to map out the trade so we bought two contracts right here at 125 right let's draw the line at 125. this is going to represent our two contracts and i'm going to be as precise as i can without being too finicky about it there we go 125 but we sold one down here at 117.50 right there all right so let's get rid of this well actually let's just let's just talk about this first potential outcome because there are a few things that this stock could do right it could go up could go down it could go basically sideways so what if it does what we thought it was going to do and it goes ramping up well that's good for these calls let's say it goes up there to 135 bucks and we own the 125 calls times two so those two calls are now doing a bang-up job for us right we have the right to buy a hundred thirty-five dollar stock for 125 bucks that's a ten dollar benefit times two that's a 2 000 benefit awesome we only spent 700 bucks for that so we'd be up 1300 on that trade however this is where i say we have to understand calls in order to under understand this strategy because you veteran you veteran traders of options tell me if this is true or not once you really understand options um somebody can throw all sorts of weird combinations of strategies at you and even if you've never heard of them before all you have to do is break it down into what did i buy and what did i sell was it a call and was it a put and as long as we can do that we understand our rights our obligations we can break down any strategy so if somebody gives me some fancy set spinning dolphin whatever strategy you came up with i don't know give me the legs of the strategy and i can figure out how it works and that's what this is so we're examining this the legs of this strategy a familiar strategy for most we're just trading call options that's it and in the entire universe of call options there are only two things you can do with them you can buy them you can sell them that's it buying we have rights selling we have obligations right so let's look at yeah and uh robert says we could expand this out to show our actually our october expiration this is only out to september right so we could pop up here or we come actually quickest way is to come down here to this little double headed arrow icon click on that change the right expansion settings and how about we crank that out to like 50 days let's see if we can capture those that yep there's october right there we don't even need 50 days i can ease back on that let's let's look at 48 or even 46 days there we go there is october so we can envision these lines right click here extend to the right right click here extend to the right because those contracts extend out to that time frame right and it says where can i go to learn more about iron condors let me address that very quickly i can't cover every strategy in a single discussion right what you can do though is i i've covered pretty much all those strategies at one time or another go to youtube after today's discussion type in my name cameron may and then type in the keywords iron condor and you'll find you know a lot of discussions you might even look i'm sure i have one out there that will say like beginner's guide to iron condors or intro to iron condor or something like that all right yeah the vast majority of our webcasts are archived to youtube so you can search them all right but back to our trade if the stock has gone up that's that's great for the two long calls but what's happening with a short call we got paid 725 theoretically for getting into this but what that means we have an obligation someone has the right to buy shares from us for 117 and a half those shares are now worth 135.
so help me do the math there i believe that's 17.50 right 17.50 of a hit that we're taking on that minus the 725 credit that we were paid from that option so that would that would be a loss on that long option of about 10 and 25 cents and as of the moment if that were if that were allowed to go to expiration or if it's assigned we'd have 10 and 25 cents on one contract that's a thousand twenty five dollars so we have a thousand twenty five dollars that we've lost on the one trade we have two thousand dollars uh minus the cost thirteen hundred bucks that we've made on the other trade and we're actually profitable it doesn't sound like a lot of profit you're saying well cameron thirteen hundred bucks on the longs and what we made we lost a thousand twenty five so we're only maybe making 275 bucks on this yes but we didn't even pay anything for the trade right and is that where it has to stop nope if the stock keeps going up what happens here is we have two long options one of which is unencumbered it has unlimited upside potential the other one has a drag applied to it by the short option so we were obligated to sell shares at 117.50 we have the right to buy those save shares for 125. there's a drag right there the other option though has unlimited reward potential so the higher the stock goes the more we can make but what if the stock goes down you think about this um yeah the short cycle be called away for 117 the net benefit is is one of the long calls pretty much chris yep yep right now and and by the way if you're thinking you know what i'm not really processing all this the very first time i'm hearing it that's okay don't feel that pressure when you learn a new strategy give yourself the excuse to take your time to absorb it trade it on paper really understand it before if you ever decide to go to real money before you ever do that thoroughly understand the strategy first all right but let's explore what else could happen what if the stock doesn't go up what if it goes down well had we just bought the two long calls this would be potentially comparatively devastating stock dropping got time going by we could lose the full investment in our long call so let's break it down what if the uh what are the stock drops let's say it goes down here to uh 115 bucks 110 bucks it doesn't matter where if it just goes down well we have the right to buy shares for 125 they're not worth that they're worth 115 they're worth 110 if we allow this to get to expiration those contracts expire worthless so we lost our seven dollar investment but if we're down here at 110 or 115 and someone has the right to buy shares from us for one 17.50 that's our short option are they going to do it probably not almost certainly not an expiration if the contract is out of money it just expires worthless with rare exceptions so so that contract expires worthless and we retain the 725 that we were paid lost seven keep 725 according to my math we make the 25 bucks on what was a bullish trade it has unlimited upside potential but limp but not only limited downside risk there's actually now because because the way we've structured this trade reward potential to the downside obviously we're setting transaction fees aside we're not really including that in this equation so it might be that we have you know some transaction fees to subtract from this but that would still be a profitable trade a profitable bullish trade that went bearish yeah did we make it do we make a huge profit no we barely scraped out a tiny little profit but i don't know do we want to make 25 bucks or or lose 700 on a pullback so yeah i think you can see when a trader isn't terribly confident that the stock is actually going to go up as dramatically as they expect maybe they ease off the throttle so unlimited upside potential there's still potential for reward to the downside does that mean that this is a flawless strategy absolutely not and lamont says why did you select a short call you're you're asking a fantastic question here lamonde isn't the short call at assignment risk uh with the stock at 119 that's a possibility when a contract is in the money and we did sell an in the money option here the the risk of early assignment is elevated now when there's still good value in that contract there's still uh a nominal assignment risk however as that as that option decays either through the passage of time and not not the option decays but the time value shrinks and that can happen through the passage of time it can also happen because the option is going deeper in the money that assignment risk can be elevated truly at any time a short option can be assigned at any point right but yeah this this the smaller the time value on the option the greater that assignment risk is particularly if the options in the money okay wayne says is there a bearish equivalent to this yep known as a put ratio back spread yeah okay so let's let's uh let's talk through a potential third scenario what if it doesn't go up above our our long strike or down below our short strike what is the worst case scenario for this trade well here's the worst case scenario if it goes up but just a little bit if it goes up there just below our 125 long options let's say it goes up to 124.99
and let's say ouch because here's what happens if it's up there at 124.99 our long options and we hit expiration they're worthless and we probably just let them expire worthless right so that's a seven dollar that's seven bucks wasted but in the meantime someone has the right to buy one basically i'm doing some rounding here skipping the penny they have a hundred they have the right to buy a 125 dollar stock for 117.50 are they going to do it almost certainly yes so that's a 750 additional loss on the short option although it um we did get paid 725 to get into that short option so how much should we actually lose on the short option in that case it would be 25 bucks right but that's in addition to the 700 that we spent on the two long options 725 dollars is the most we can lose on this trade and that's if the stock were to rally but come up just shy of the 125. if it's if it's below that let's say we're at 120 well now we have to provide a 120 stock for 117.50 that would be a 250 loss against the 725 we were paid on the short option we'd actually be profitable on a short option and but lose our our long option investment but in any case what i hope you're seeing here is that when we learn a new strategy break it down leg by leg do the math add it up and see where we make our best money where we where we have the greatest exposure to risk the greatest exposure risk on this trade is right in this range best profit is going to be the higher we can go and actually if we start to rally and we get up above if we start to move up quickly this trade can be profitable immediately it's not that we have to be all the way up at 135 at expiration in order to generate a profit okay so bias that's how to manage the trade when it goes against us well what truly means what does it truly mean going against us if the stock is going down it's not the trade's not working optimally but it's not necessarily going against us either in this case it would be if the stock is starting to drag out between where we are right now and our long options if we're if we're just sort of hanging out in this range we might want to think about just closing the trade okay okay all right so let's go place the trade how do we place this trade we pop up here and we a couple of different ways we can do it we can change the spread from single to back or ratio spread or another thing that we can do is just hold down our control key and start clicking i'm going to do that i'm going to go to us the single and i'm going to go to the options that we intended to buy the 125s and i'm going to click on the ask price and then i'm going to go back up and hold down the control key and click on the bid price for the 117 and a half and there's our ratio spread let's hide this left column for just a moment oh you know what my apologies yep i got i i typically do it i try to stay consistent from one trade to the next you can't do it that way so we're gonna have to use the back ratio spread approach let's come to our 125 and and we're going to buy that click on that and that creates a a ratio one to two but the um the ratio is 10 contracts and 20 contracts let's just make that one and two so i'm just going to erase the zeros now we're buying the 125 calls but we wanted to sell the 117 and a half so let's go to 117 and a half there we go and you can see that's about a 25 cent credit that's what we were shooting for let's dial that down a little bit let's say that we're willing to settle for you know 25 even a 20 cent credit the the uh the credit is not what we were really intrigued by here oh no let's say let's admit that matter of fact just in the interest of time i'm going to make everybody super nervous and i think this is going to be a an educational opportunity anyway if i put this in as a market order i don't ever do that but maybe it's a good opportunity to talk through this when we place a market order we're literally literally saying hey i'll pay whatever price i i'm required to to uh to enter this trade and we could be quite unsatisfied with it with the price that we received there's a danger in doing this that's kind of why i'm doing it i want everybody's blood pressure to go up and think about the exposure that we have here but i'm going to click confirm and send and um and let's buy this back ratio spread and as we do that final thing that i want to address is why is it referred to as a back ratio spread well i this is the way that i think about it when you go to a concert how does the pricing of the seats work that the expensive seats are in the front kind of like the in the money options the the uh the cheap seats are in the back like the out of the money options right and where do we have um more contracts in the back there's a ratio of two to one weighted toward the back it's back ratio spread that's the way i think about it in any case let's enter this trade notice max profit infinite max loss depends on our fill we calculated about 725 this is saying 720 close enough right there is a transaction fee of buck 95 in this example trade let's send this order off see what we got it for oh look at that we filled at zero okay so there was no cost to this trade however there is an impact to our buying power because uh that 720 loss potential or whatever it turns out to be 725 something in that range that's going to be held up in our mind power but there's our trade infinite upside potential essentially zero downside risk but there is risk if the stock starts to float around that long strike that's where we don't want the price to go all right everybody we've actually accomplished everything that i set out to do today let's do a quick recap when we started off this discussion we quickly address the three questions with a with a very brief market review so that we could focus on this bullish buying strategy with a high reward potential but i think you notice not a strong probability of success because it has a strong directional bias we need the stock to go up not really any exposure to the downside a dramatic downside move the real exposure is we just sort of hang out and go sideways okay um everybody thanks for giving me your time today it's definitely appreciated if you would do me this favor pop down there click on that subscribe button helps out our channel it also helps you follow your favorite instructors uh more readily you can also follow me and barb on twitter at the armstrong underscore tda at cma underscore tda and uh and this is what we do on thursday morning so i hope you put it in your personal calendar to join me in selecting an option strategy thursday morning of course you're invited to join me up in my other regularly scheduled sessions monday tuesday wednesday thursday of each week but go enjoy the rest of your day we have lots of education left on the on the calendar for the day but as i let you go just remember that risks are real we did use real examples in today's discussion it's not a recommendation or endorsement of those securities or those strategies right i'll see you on twitter i'll see you in my other webcast but hey whenever i see you again until that moment arrives i want to wish you the very best of luck happy trading bye [Music] [Music] you