Trading a Ratio Put Spread

01/05/2010 12:01 am EST

Focus: OPTIONS

Options are eroding assets; therefore, it isn't always wise to spend a lot of money to purchase an option that will face depreciation as well as dismal odds of success. Instead, it is often a better idea to sell options of different types or strike prices in order to pay for those that you would like to purchase. A put ratio spread does just that.

A trader who is interested in buying a put option in hopes of a market decline or to simply protect other positions in their trading portfolio may finance their purchase through the sale of two distant strike priced puts. Here are the details of a put option ratio spread:

Put Ratio Spread
* Buy one at-the-money put
* Sell two or more out-of-the-money puts

When to Use
 * When you expect the market to market to move lower, but believe that the downside is limited

The objective is to put this trade on as a credit, a free trade, or very cheaply. This occurs when a trader collects more premium for the short options that is put forth for the long options. Free does not entail a lack of transaction costs, margin, or risk.

Profit Profile
* If executed at a credit, the profit is limited to the premium collected if the market is above the long put at expiration
* Profit on the down side is limited to the difference between the long and short puts, plus the net credit, or minus the net debit

What Is at Stake?
* If the market expires above the long put, your risk is limited to any premium paid for the spread if executed as a debit
* Because this trade involves more short puts than long, the downside risk is unlimited below the short puts
* Having unlimited risk, this trade needs to be watched closely

Example

In my opinion, one of the most opportune markets to employ a put ratio spread strategy in is the stock indices. During times of excessive volatility, it is possible to construct a very large spread—which translates into a large profit zone—at very little cost or possibly even a net credit.

Back in September 2008, the equity markets were extremely volatile. It is a good time to use as an example of when this strategy works. Back then, we wrote:

“If you prefer the big board (S&P 500), based on today's settlements, it may be possible to buy the November 1160 put and sell two of the 1080's for near even money. Assuming an even money fill, this trade makes something from 1160 to 1000. The maximum profit of $20,000 occurs if the market is at 1080 at expiration, and the risk is unlimited (equivalent to being long a futures) below 1000.”

A put ratio spread (such as the one noted below) can be used by bears as a way to enter the market without the immediate risk of a futures contract. The bulls may look to use such a put ratio spread as a means of hedging against bullish strategies. In this case, it can often be looked at as cheap insurance. However, this insurance policy has a deductible in the form of downside price risk should the market drop extremely sharply. Let us explain the mechanics by looking at the recommended trade in detail.

NEXT: Planning and Implementing a Ratio Put Spread

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Planning and Implementing a Ratio Put Spread

We will assume that the trade above could have been executed at even money, however, in all actuality, it may have been a credit. Even money simply means that the trader is collecting the same amount of premium for the short options as is being paid out for the long option. In other words, from a cash outlay standpoint, the trade is free. Keep in mind that free doesn't imply without risk of loss or margin.

This trade involves a long put and two short puts; thus, it faces theoretically unlimited risk beyond the reverse break-even point. Likewise, the exposure of the short puts creates limited profit potential in that gains on the long put will eventually be offset by losses in the two short puts should the market decline below 1080. In this instance, the profit is limited to a handsome sum of $20,000; calculated by multiplying the distance between the long put and the short put by the multiplier for the contract ($250). If you are trading mini's, the point value is one-fifth the size of the full-sized contract, making the maximum profit potential $4,000. While the risk will be unlimited whether you are trading the mini or the "big board," the mini contract will lose at a pace of one-fifth that of the full-sized version.


Click to Enlarge

The simplest way to explain the payout diagram of this trade is based on the potential payout at expiration (see Figure 1). Upon expiration of this spread, and assuming an even money fill, it will be profitable with the futures price trading anywhere from 1160 to 1000 without regard to transaction costs. In essence, the spread makes money as from 1160 down to 1080, but below 1080, the trade is giving back profits until it runs out of money near 1000. As the futures price drops below 1000, the trader faces theoretically unlimited risk. Such a scenario is similar to being long a futures contract from 1000. For every point that the futures price moves below the reverse break-even point, the trader loses $250 on a full-sized contract ($50 if you are trading minis). I would like to point out that there is only one way for this trade to be a loser at expiration, and that is if the futures market is trading beneath 1000. Ignoring transaction costs, at any point above 1000, the trade is either breaking even or profitable.

Unlimited Risk? Yes. But Is it Likely?

Keep in mind that while this trade does face unlimited risk, the risk is distant from the market price at the time of entry. This is in stark contrast to the risk faced by a futures trader. I have learned that you can never underestimate the markets, but the odds of a 160-point plunge in the S&P after the market had already suffered a nearly 200-point drop previous to this recommendation seem highly unlikely.

Put Ratios for Risk Management

As mentioned above, this trade can be used as an insurance policy. I have been known to point clients toward a trade similar to this one as a means of providing a quasi hedge against short put positions that are under pressure. At expiration, this spread insures a move below 1160 to 1080, tick for tick. As explained, below 1080, the trade gives back profits; thus the insurance policy begins to become less valuable. Below 1000, the trade that was meant to be a hedge now becomes a burden. Therefore, when using ratio spreads as a means of risk management, you should be aware of major support and resistance levels and place the strike prices of the spread accordingly.

Disadvantage of Ratio Put Spreads

It is important to note that a ratio spread can sometimes involve unintended consequences at any point prior to expiration. At expiration, there is no time value in the options and the profit and loss will be strictly dependent on the diagram pointed out in Figure 1. However, due to the time value still present in the options, it is possible for a spike in volatility to create a scenario in which the combined value of the short puts gain in value faster than that of the long put. In other words, it is possible for the market to move in the anticipated direction and create a loss to the trader. Assuming that the futures contract is trading above the reverse break even at expiration, the losses will only be temporary; however, it is never fun to be a part of.

Conclusion

Ratio spreads can be a powerful trading tool, but proper construction and execution are the keys to producing favorable results. Poor timing in terms of volatility and price, along with incorrect strike price placement, may result in a very unpleasant trading experience.

By Carley Garner

Carley Garner is senior market analyst and broker with DeCarley Trading and a columnist for Stocks and Commodities.

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