Call Ratio Spreads

This is another nice strategy that often provides a wide profit zone. When a market makes a big up move, relatively quickly, the general public rushes in and buys out-of-the-money call options. This causes those options to be overpriced in relation to the at-the-money call options.

Here's how you can take advantage of this situation:

Look at price charts and find a market that has just made a fast up move and is now slowing down or even topping out. This often happens when there is a weather scare which affects markets such as soybeans, coffee, etc. But it can occur in almost any market.

Once you find a market like this, look at all of the options for the given underlying asset.

If you notice the out-of-the-money call options have a significantly higher implied volatility than call options which are closer to the money, you can capitalize on this pricing disparity by setting up a call ratio spread as follows:

	Buy one or more options and at the same, sell a larger number of options further out-of-the-money. For example, you might buy 1 call option at-the-money and sell 2 call options out-of-the-money (which you have identified as being overpriced).
	Another variation is to buy 1 call option out-of-the-money and sell 2 call options that are further out-of-the-money.
	You can also use a different ratio other than 1 to 2. For instance, you might buy two options at-the-money and sell 3 options out-of-the-money.

You normally want do this trade only if you receive a credit because this will give you a very large profit zone that stretches from zero all the way up to a price which exceeds your upper strike price.

Example: Call Ratio Spread using S&P 500 index futures options

	Market price of S&P 500 futures ......................... 651.50
	Buy 1 June S&P 500 670 Call option @ ................ 15.00
	Sell 2 June S&P 500 690 Call options @ ................ 9.00
	Net credit = (9.00 x 2) - 15.00 = 3.00 points x $500/point = $1500
	Profit zone .............................................. 0.00 to 713.00
	Profit within the profit zone ................... $1500 to $11,500
	Probability of profit .................................................. 91%
	Margin Required ................................................... $8500
	Note: The profit zone is the range of values which the underlying must fall within when the options expire, for the strategy to be profitable.

As you can see, the call ratio strategy has a couple of distinct advantages:

	If you do it for a net credit, your profit zone can be quite wide. This gives you a high probability of making a profit.
	The potential profit can also be quite large.

It also has a potential problem to watch out for. If the price of the underlying asset rises up to the strike price of the options you sold, they will go in-the-money. At that point, you should consider closing out the position, to play it safe.