An options trader, however, is not limited to this straightforward equation; he or she can enter a position that will make money if the underlying security goes up a lot, goes up a little, stays in a particular range, goes down a little, and so on and so forth. The key to success is to understand the actual reward-to-risk characteristics for a given strategy and apply the appropriate strategy at the appropriate time. To learn more on how options can be used to customize your trade, check out our Options Basics Tutorial.

One strategy that offers a unique reward-to-risk profile is known as the "long ratio backspread. Most traders new to options focus on writing covered calls - which limits profit potential and offsets only a small portion of downside risk - or buying calls and puts - which offer unlimited profit potential but which also run the risk of a complete loss of the premium paid if the underlying security fails to move in the anticipated direction.

Check out our related article Backspreads: Good News For Breakout Traders to learn more about backspreads and their uses.

A long ratio backspread allows a bullish trader to enjoy unlimited upside profit potential as well as the opportunity to make a profit if the underlying security declines in price. Likewise, a trader who is bearish can enjoy unlimited profit potential if the security declines in price, as well as the opportunity to make a small profit if the underlying security rises in price. As with any strategy, there is no free lunch.

Whether using call or put options, this strategy can lose money if the underlying security remains in a trading range until option expiration. Definition of a Long Ratio Backspread A long ratio backspread for the sake of simplicity, heretofore referred to simply as a "backspread" can use either call or put options, depending on whether you primarily expect the underlying security to rise or fall in price. Most typically this is done in a ratio of 1: In other words, a trader who is bullish on a particular stock might sell one call option with a strike price of 20 and buy two call options with a strike price of This is known as a call ratio backspread.

On the other end of the spectrum, a trader who is bearish on a given stock might sell two put options with a strike price of 55 and buy three put options with a strike price of This is known as a put ratio backspread.

Together, they are both known as long ratio backspreads because the long component of each is larger than the short components. Example To better illustrate this concept, let's look at an example.

Ratio Spread | Ratio Spread Options Strategy | tastytrade | a real financial network

In Figure 1, you see a bar chart for the stock of Celgene Nasdaq: As you can see in the bar chart, CELG had recently formed a double top and the day moving average had dropped below the day moving average.

This combination of factors might prompt some traders to look for a move to the downside. Read the Moving Averages section of our Technical Analysis Tutorial to learn more about this signal. The options in this example have days left until they expire. Figure 2 displays the resultant risk curves for this trade. As you can see in Figure 2, if CELG declines in price, this trade enjoys unlimited profit potential. The risk curves illustrate the concept of time decay.

Option prices have a certain amount of "time premium" built into them. The time premium built into the price of each option essentially serves as an inducement for someone to assume the risk of writing a particular option. All time premium evaporates by the time an option expires.

This process accelerates rapidly in the last 30 days prior to expiration. This phenomenon can be viewed in Chart 2.

You will notice that during the early stages of the trade it is almost impossible to lose a lot of money.

Call Ratio Backspread

It is not until expiration approaches that the risk curve breaks sharply to the negative side. To learn more about time premium and its decay, read The Importance Of Time Value.

This is one of the most attractive features of a long ratio backspread. A trade can be entered and held for a significant period of time without the risk of a large loss. If a trader resolves to exit a backspread prior to expiration he or she can never experience the maximum potential risk associated with the trade.

The Bottom Line Many beginners focus on buying calls or puts in an effort to leverage a market timing opinion. And while the potential rewards are great, the fact remains that no one bats 1, If you trade enough there will be times when the underlying security will do exactly the opposite to what you expect.

Individuals who truly seek the best opportunities might do well to learn more about this unique option trading strategy. Dictionary Term Of The Day. A measure of what it costs an investment company to operate a mutual fund. Latest Videos PeerStreet Offers New Way to Bet on Housing New to Buying Bitcoin? This Mistake Could Cost You Guides Stock Basics Economics Basics Options Basics Exam Prep Series 7 Exam CFA Level 1 Series 65 Exam.

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The Basics Of The Long Ratio Backspread By Jay Kaeppel Share. To enter a backspread using call options a trader would: Sell a call option with a lower strike price and; Simultaneously buy a greater number of call options with a higher strike price.

Celgene Stock "rolling over" from a double top Source: Risk curves for CELG put ratio backspread option position Source: Optionetics Platinum As you can see in Figure 2, if CELG declines in price, this trade enjoys unlimited profit potential.

This bullish trading strategy offers unlimited potential profit with limited risk. Options offer alternative strategies for investors to profit from trading underlying securities, provided the beginner understands the pros and cons. The adage "know thyself"--and thy risk tolerance, thy underlying, and thy markets--applies to options trading if you want it to do it profitably.

Learn how to multiply returns and diversify risk by buying options instead of stock. Trading the commodities can mean extra expenses. These commodity-based ETFs give you the flexibility of trading like stocks.

Learn more about stock options, including some basic terminology and the source of profits.

Call Backspread Explained | Online Option Trading Guide

Trading options is not easy and should only be done under the guidance of a professional. It seems counterintuitive that you would be able to profit from an increase in the price of an underlying asset by using Understand how options may be used in both bullish and bearish markets, and learn the basics of options pricing and certain Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered Learn about investing in put options and the associated risks.

Explore how options can provide risk, which is precisely defined An expense ratio is determined through an annual A hybrid of debt and equity financing that is typically used to finance the expansion of existing companies.

A period of time in which all factors of production and costs are variable. In the long run, firms are able to adjust all A legal agreement created by the courts between two parties who did not have a previous obligation to each other. A macroeconomic theory to explain the cause-and-effect relationship between rising wages and rising prices, or inflation.

A statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over No thanks, I prefer not making money.

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