The Ratio Option Spread
Greetings Traders, welcome to this week's option trading lesson!
In today's lesson I'm going to discuss one of my favorite option
strategies. The Ratio Option Spread.
The "RATIO OPTION SPREAD" A ratio spread is initiated by
purchasing a close-to-the-money option and selling two or more farther
out-of-the-money options; for example, with July soybeans trading at $8,
we may decide to purchase a July soybean $9 call and sell two $12 calls.
Let's assume that the $9 call is trading at a premium of 20 cents and the
$12 call at a premium of 12 cents. We would then pay 20 cents for the $9
call ($.20 x $50 per penny = $1,000); and receive two times 12 cents or 24
cents for the $12 calls we sell ($.24 x $50 = $1,200). In this case, since
we receive $200 more than we paid out, we are doing the spread at a credit
of 4 cents or $200.
Receiving this credit is very important when doing the ratio spread, and
beneficial for the following reasons:
1. Firstly, if the market goes up as we expect in this example, we will
receive a profit of $50 for every penny soybeans move over $9 at
expiration (up to $12) for a maximum profit potential of $15,000.
2. Unlike a normal option purchase, there is no cost for your initial
option purchase because it was paid for by the sale of the $12 calls.
3. In making this trade, we are also taking advantage of premium disparity
in option premiums between strike prices. We find in most markets,
particularly in grains and metals, that options that are
closer-to-the-money have lower volatility (premium cost) than farther
out-of-the-money options.
These out-of-the-money options have no intrinsic value because they have
only what is known as "time value premium" This is a specific
amount people will pay for an option because it has a chance of becoming
valuable some time in the future.
We find that this time value premium decreases the farther
out-of-the-money; however, there seems to be more demand by smaller
traders to purchase "cheap" options. This can greatly increase
the time value of these out-of-the-money options to a point where they, at
times, are much more expensive than one might expect. Because the options
are so far out-of-the-money, it is very unlikely that the options will go
into-the-money, yet the premiums do not reflect this lack of probability.
Thus, they are relative to the probability of profit, much more expensive
than the close-to-the-money options. By using the ratio spread we can take
advantage of this disparity in premium since it allows us to purchase the
most reasonably priced close-to-the-money option and sell the relatively
more expensive options that are farther out-of-the-money.
4. The farther out-of-the-money options we sell will also lose there time
value faster as they approach expiration. Time value decreases for both an
option at-the-money and out-of-the-money as it approaches expiration. This
decline in time value is much more dramatic for the out-of-the-money
option.
5. Finally, one of the biggest benefits of the ratio spread, is the fact
that, if the market does not move as expected, as long as we gain a credit
when the spread is initiated, we will not have a loss. In my soybean
sample above, let's assume that soybeans are plentiful and the price of
soybeans drop to $4. In that case, the options we purchased and sold will
all be worthless at expiration. At that time, the net difference to our
account from taking this position will be the 4 cent net premium we
collected when we initiated this position; therefore, our account will
increase by $200, even though the market moved against us.
There is only one situation where this position can run into trouble, and
that is, if the futures price exceeds the strike price of the options
sold. To help control the potential for large losses under these
conditions, we follow a rule that requires us to close out our ratio
spread if the futures price exceeds the strike price of our short options.
The best time to initiate a ratio spread is when the market has made a
quick straight up move. This is because this type of action normally
increases the demand for out-of-the-money "cheap" options for
the reasons mentioned above. This also seems to be when there is great
disparity in premiums between the close-to-the-money and out-of-the-money
options, providing the best opportunity for the ratio spread.
I feel that the benefits of the ratio spread far outweigh the single
problem area, that of the market rising to quickly, to soon. Also, these
problems are easily handled by our contingency plan and the rules I
described above. The ability to initiate a spread that can be profitable
over a wide range of prices and market conditions allows us to have both
financial and emotional security in the markets.
The reason for giving the Ratio Spread lesson today is because the U.S.
grain growing season is about to get underway, and there is no better time
to consider the ratio spread. Every growing season has surprises in
weather conditions that cause volatility extremes making out-of-the-money
way over valued. This generally occurs from April into July creating the
perfect atmosphere to gain a credit when the trade is initiated.
In the following chart example you can see that price spikes almost
always occur during this time: NOTE: the chart below
is from 2006 but the seasonal trend remains intact through 2009.
Notice how prices drop just after the late spring and summer price
highs. Initiating the ratio spread just prior to these times gives you the
edge because those out-of-the-money options sold will lose value very
quickly.
Within the next three months we'll be entering the ratio spreads in the
grains and soybean complex to take advantage of the high Implied Option
Volatility to gain a credit thus eliminating the risk of loss.
The Ratio Option Spread you learned here today and the Free
Trade Option Position are two positions that eliminate
losses. Beginners and not yet successful traders should consider these two
strategies that create stress free trades which in turn creates a more
relaxed trader.
If you've found this lesson beneficial to your trading consider
getting us a coffee: CLICK HERE.
Trade Well,
Archie
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