Buy Stock+Ratio Call Spread

A.K.A. Long Stock + Ratio Call Spread

investment

Opinion: Bullish to very Bullish.

Example:

Long 1 Oct 60 Call @ 5
Short 2 Oct 65 Calls @ 3
Long 100 Shares XYZ @ $60

Description: This is a useful strategy for a stock investor who wants to start to accumulate a position in XYZ at current levels. For example, an investor thinks that XYZ is “bottoming”and wants to buy 200 shares. Although confident, the investor wants to only buy 1/2 now in case XYZ moves lower.

Strategy Profile: This is one of many strategies that allows the investor to establish a bullish position without assuming all the risk associated with stock ownership.

Obviously, a position containing 100 shares of XYZ has less downside risk than the full 200 share position that the investor wants to accumulate.

It may appear complex, but the spread can be broken down into two bullish spreads:

1 Covered Write:
Long 100 Shares XYZ @ $60
Short 1 Oct 65 Call @ 3

1 Bull Call Spread:
Long 1 Oct 60 Call @ 5
Short 1 Oct 65 Call @ 3

When to use: Even though it contain only 1/2 of the 200 XYZ shares that the investor wishes to accumulate, it is important to remember the downside risks inherent in any stock position.

Usually, the options are selected so that the Call Spread is established for a small debit or even a credit (buying 1, writing 2).

Tradeoff: In order to lower the downside risk, the investor has to accept limited profit potential to the upside should XYZ have a large rally.

Profit & Loss Characteristics: The spread’s maximum profit potential is reached at or above the striking price of the written Calls (65) at expiration.

Because stock investor ownership exists, the downside risk can be large if XYZ has a large decline.

Depending on the initial price of the Call spread, this strategy’s P&L can approach that of a 200 share position if XYZ is at $65 at expiration! Thus, the investor can have nearly the same profit at $65 with only 100 shares!

Break-even Points: Stock Price + spread debit (or minus spread credit).

Time Decay: Positive. If XYZ is near the strike price of the two written Calls (65), profits from decay accelerate most rapidly over time.

If XYZ stays near $60, profits from decay of the 65 Calls offset loses on the 60 Call. As expiration approaches, the spread’s price becomes mostly a function of the price of the 60 Call.

Volatility: An increase in volatility is a negative. The impact will depend of time left until expiration and the price of XYZ relative to the two strike prices.

Because of this, it is important that the implied volatilities of XYZ’s options be high enough to allow the spread to be established for near zero.

Assignment Risk: The investor must continuously monitor XYZ for possible assignment if the 65 Calls become in-the-money prior to their expiration.