Chapter 13: Reverse Spreads 
Buy 2 July 45 calls at 1 each 
Sell 1 July 40 call at 4 
Net 
2 debit 
4 credit 
2 credit 
233 
These spreads are generally established for credits. In fact, if the spread cannot 
be initiated at a credit, it is usually not attractive. If the underlying stock drops in 
price and is below 40 at July expiration, all the calls will expire worthless and the 
strategist will make a profit equal to his initial credit. The maximum downside poten­
tial of the reverse ratio spread is equal to the initial credit received. On the other 
hand, if the stock rallies substantially, the potential upside profits are unlimited, since 
the spreader owns more calls than he is short. Simplistically, the investor is bullish 
and is buying out-of the-money calls but is simultaneously hedging himself by selling 
another call. He can profit if the stock rises in price, as he thought it would, but he 
also profits if the stock collapses and all the calls expire worthless. 
This strategy has limited risk. With most spreads, the maximum loss is attained 
at expiration at the striking price of the purchased call. This is a true statement for 
backspreads. 
Example: IfXYZ is at exactly 45 at July expiration, the July 45 calls will expire worth­
less for a loss of $200 and the July 40 call will have to be bought back for 5 points, a 
$100 loss on that call. The total loss would thus be $300, and this is the most that can 
be lost in this example. If the underlying stock should rally dramatically, this strategy 
has unlimited profit potential, since there are two long calls for each short one. In 
fact, one can always compute the upside break-even point at expiration. That break­
even point happens to be 48 in this example. At 48 at July expiration, each July 45 
call would be worth 3 points, for a net gain of $400 on the two of them. The July 40 
call would be worth 8 with the stock at 48 at expiration, representing a $400 loss on 
that call. Thus, the gain and the loss are offsetting and the spread breaks even, except 
for commissions, at 48 at expiration. If the stock is higher than 48 at July expiration, 
profits will result. 
Table 13-1 and Figure 13-2 depict the potential profits and losses from this 
example of a reverse ratio spread. Note that the profit graph is exactly like the prof­
it graph of a ratio spread that has been rotated around the stock price axis. Refer to 
Figure 11-1 for a graph of the ratio spread. There is actually a range outside of which 
profits can be made - below 42 or above 48 in this example. The maximum loss 
occurs at the striking price of the purchased calls, or 45, at expiration. 
There are no naked calls in this strategy, so the investment is relatively small. 
The strategy is actually a long call added to a bear spread. In this example, the bear