A ratio spread is a strategy that allows you to take advantage of a market breakout, even if you don’t know which direction it will be. You can benefit from a range-bound market, and use option theta, or time decay, in your favor. The ratio spread involves holding an unequal number of long and short positions via options. Usually the options are at different strike prices, with the same expiration date. I will provide an example of this strategy in the crude oil market, but the concept can be applied to any market.
Keep in mind, a ratio spread can involve a high degree of risk, so this strategy is not right for everyone. However, for investors with a good understanding of the mechanics involved, it can offer an inexpensive way to enter a position, and can potentially be quite rewarding.
Example: Crude Oil Ratio Spread
Let’s look at an example of a ratio spread in the crude oil market. We’ll consider the January crude oil options, which expire December 15, 2010. January crude oil futures were trading near $81.70 when options prices in this example were quoted on November 22, 2010. Initial margin is $2,310. These figures are subject to change. Profit-loss scenarios for this example will be given at options expiration, as that’s when we can determine exact price points. As mentioned, a ratio spread involves holding multiple positions at the same time. A 1×2 ratio spread is a common construction, with positions to the upside and downside that offer you a wide price range to be successful. So here’s how we would execute it in the crude oil market.
Buy one January 84 crude oil call at $1,460
Sell two January 87 crude oil calls at $650, or $1,300 total
With these two positions, you are paying $1,460 for the calls purchased, but you collect $1,300 in premium for the calls sold. So your total cost for the trade is $160, plus commission charges.
What we want to see happen with this trade is for crude oil to be priced at $87 at expiration. Your 87 calls expire worthless, but your 84 calls are $3 in the money, netting you about $3,000 on the trade, not including your commission costs.
This ratio spread not only includes call positions, but also involves positions on the put side. So here’s the second part of our strategy.
Buy one January 80 crude oil put at $1,750
Sell two January 77 crude oil puts at $950, or $1,900 total.
Here, we would want crude oil to be priced at $77 at expiration. Your 80 put is worth $3,000 and the 77 puts are worthless.
Similar to the call side of the trade, the premium you collect for the puts you sold offsets the cost you paid for the puts you purchased. You net $150, not including commission costs. Putting both parts of this strategy together, you paid $160 for the call side, and collected $150 for the put side. You can see both sides of this position essentially net out with a small upfront cost to you ($10 plus commission charges).
You are looking to exploit time decay. If the market trends too strongly in one direction, you can face potentially unlimited risk. However, if you start to feel nervous about a strong upside breakout occurring, you can adjust your position to limit your risk. What you would do is buy the strike $3 beyond your two shorts. You could buy a 90 call and limit your risk in this example. This turns your position into what’s known as a butterfly.
The ultimate goal is for the market to settle closest to our short options strikes at expiration. We want the market to trade to either $87 or $77 for maximum profit potential, but those aren’t absolute levels.
If crude oil is trading from $80 – $84 at expiration, all options expire worthless, and your trade is a wash. If crude oil is priced at $85 or at $79, the long options are each $1 in the money, and are worth $1,000. The short options are worthless (but remember, you still get to keep the premium you collected).
What happens to this trade if crude oil is at $78? The calls are worthless, and the 77 put is worthless, but the 80 put is worth $2,000. If crude oil is at $75, the 80 put is worth $5,000, and the two short 77 puts will go against you $2,000 each. So you net $1,000 on the trade in this case. You have to ask yourself: If you are bearish, can you reasonably see a move to $79 – $75 by expiration? If you are bullish, can you reasonably see $87 on the upside by expiration? If the answer is yes to either, this strategy might be worth considering.
Therefore, as mentioned, our best-case outcome is for crude to either break out to the upside to $87, or to the downside to $77. Those levels make the short options virtually worthless, and put maximum value in the long positions.
Please feel free to ask me any questions you have about this topic, and how it can be applied to other markets. I’d also be happy to help you develop a customized strategy based on your unique needs and risk tolerance.
Steve Kauppi is a Senior Market Strategist at Lind-Waldock. He can be reached at 866-317-9477 or via email at skaupi@lind-waldock.com.
Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
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