7/16/22, 11:51 AM 1x2 Ratio Vertical Spread with Calls - Fidelity

1x2 ratio vertical spread with calls

THE OPTIONS INSTITUTE AT CBOE®

Options

Potential goals
To profit from a stock price move to the strike price of the short calls with limited
downside risk.

Explanation

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

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.

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.
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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 Long 1 100 Call Short 2 105 Calls Net Profit/(Loss) at
Expiration Profit/(Loss) at Profit/(Loss) at Expiration

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Expiration 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).

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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

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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

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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.

Related Strategies

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1x2 ratio vertical spread with puts

A 1x2 ratio vertical spread with puts is created by buying one higher-strike put and selling
two lower-strike puts.

Article copyright 2013 by Chicago Board Options Exchange, Inc (CBOE). Reprinted with permission from CBOE. The
statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the
accuracy or completeness of any statements or data.

Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies
carry additional risk. Before trading options, please read Characteristics and Risks of Standardized Options .
Supporting documentation for any claims, if applicable, will be furnished upon request.

Greeks are mathematical calculations used to determine the effect of various factors on options.
Charts, screenshots,
company stock symbols and examples contained in this module are for illustrative purposes only.

682796.3.1

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