How to Trade Option Ratio Spreads (Part 1)

11/23/2010 12:01 am EST

Focus: OPTIONS

Mark Wolfinger

Educator, MDWoptions

There are several commonly used option strategies that never get mentioned at Options for Rookies. I have my reasons for ignoring those strategies, however, because my blog is an options education site, it's worthwhile to describe some of these methods and explain the pros and cons of using them. Then each reader can judge whether or not such strategies are appropriate.

One such strategy is the ratio spread. It is sometimes referred to as a “front spread” because it is the direct opposite of a back spread.

Ratio Spread

This term can have a broad or narrow definition. It's the narrow definition that is used most frequently.

Broad definition: A ratio spread is any option strategy in which the trader sells more options than he/she buys. 

The more limiting definition includes: Similar to a vertical spread, all options are on the same underlying stock or index and have the same expiration date. Only the strike price differs. The options sold always have a smaller delta than the options bought.

Many times the ratio spread is initiated as a delta-neutral position. However, when you are trading with a market bias, you may prefer to select specific options and a specific ratio to suit your market expectations (more on that tomorrow).  Let's look at examples.

Note: The following are randomly chosen spreads and are not recommendations. I will not be trading any of these examples for my own account.

Ratio Call Spread Example:
Buy 1 AAPL January 330 call
Sell 2 AAPL January 350 calls

This is referred to as a "1 x 2 call spread," with “x” being used to represent the word “by.”

As I write this (November 18 after the market close), AAPL is $308.43 and the estimated execution prices for this trade are $6.60 and $2.70. The trader pays $6.60 for the call purchased and collects $2.70 for each call ($5.40 total) sold. Thus, the cost to buy this position is $1.20. As with any other options trade, that $1.20 is per share and the true cost is $120.

The total description of this trade is: "The trader bought the January APPL 330/350 1 x 2 call ratio spread at a net debit of $1.20"

Important Note: If you describe this trade verbally, especially when entering the order through your broker, you must use the lowest common denominator for the ratio. 

In other words, if you enter this trade 20 x 40, the terminology is: "Buy 20 1 x 2 spreads at a net debit of one dollar and twenty cents for each 1 by 2." Never tell the broker that this is a total debit of $2,400 ($120 x 20).

Ratio Put Spread Example:
Buy 2 AAPL January 270 Puts @ $7.10
Sell 3 AAPL January 260 Puts @ $5.20

This is a "Jan AAPL 270/260 2 by 3 put ratio spread at a net credit of $1.40"

This position is initiated with the trader collecting a cash credit of $140.

NEXT: So What's the Problem with Ratio Spreads?

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What's the Problem?

There is nothing truly “wrong” with spreads of this type, and experienced traders use them as part of their trading arsenals. The main reason that I don't discuss ratio spreads is because they are positions in which you would be “net short” options. These are referred to as “naked” shorts.

Many brokerage firms do not allow any of their customers to own positions with naked call options.  Others allow experienced traders to sell naked puts and calls. Thus, some of you would be limited in your ability to trade this type of position, depending on the whim of your broker.

Risk management. That's the problem. The major focus of this article and my blog is to help rookie option traders learn to trade options successfully. To do that, it's very important to recognize and control risk in the form of “How much money can I lose on this trade in the worst case scenario?”  Naked short positions make it impossible to gauge a worst case (for calls) and it becomes difficult to keep a handle on current risk.

When short naked options, the loss is theoretically unlimited for calls and the value of the strike price (x 100) for puts. In reality those extremes do not occur, but gigantic losses are possible. That's why I never suggest that rookie option traders ever hold positions that are naked short any call options. I make one exception for holding naked put options: If you want to accumulate stock positions for your portfolio, one acceptable method for attempting to do that is to sell naked put options.

The combination of:

  1. Horrific results are unlikely but are possible
  2. In general, brokers do not allow inexperienced traders to sell naked options
  3. I believe that it takes a good deal of experience before considering selling naked options
  4. I never sell them myself (simply because margin requirements are too high)

This puts me on record for not recommending these trades to my audience of rookie traders. Many experienced traders can handle these spreads because they have seen what the market can do. I assume that any trader who has been in the game long enough to has gained significant experience survived because he/she already understands the importance of managing risk. (That's my way of saying that traders who ignore risk will not survive very long.)

Broken Wing Butterfly (BWB)

One other possibility for limiting risk and making the ratio spread a viable alternative is to buy one extra call or put option for each option sold. In other words, there are no longer any naked shorts.  That option:

- Is farther out of the money (OTM) than the short options
- Provides ultimate protection by: 

    1. Limiting losses
    2. Reducing margin requirements
    3. Creating a position that all brokers will accept

This new position is known as a butterfly spread if the options owned are equally distant from the options sold.

Butterfly example:
Buy one AAPL January 330 call
Sell two AAPL January 350 calls
Buy one AAPL Jan 370 call

In most scenarios, the option bought is farther OTM and the distances are unequal. That new position is called a broken wing butterfly and is a position typically adopted by more conservative traders who want to trade ratio spreads.

Broken Wing Butterfly (BWB) Example:
Buy one AAPL 380 (or higher strike) call…instead of buying the January 370 call
I'll have more to say about BWBs later in this series.

Next time I'll discuss the risk profile for ratio spreads and how your market outlook plays a role in choosing strike prices when trading ratio spreads.

By Mark Wolfinger of Options for Rookies

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