How to Trade a Ratio Put Spread

11/24/2011 8:00 am EST

Focus: OPTIONS

Greg Harmon of Dragonfly Capital explains one of the proven option strategies he utilizes citing a trade on Salesforce.com (CRM) as an example.

There are many different strategies that I use with options, and over the next few weeks, I will continue to go through some of them to help explain the strategies and how they can be used to access the market with controlled risk. The first two in this series were the Call Spread Risk Reversal and the Put Butterfly. Today, we will discuss the Ratio Put Spread.

Ratio Put Spread

This strategy consists of buying one put option, selling two lower-strike puts to create the ratio put spread. The sold puts can be the same strike or different strikes, making it a split ratio. It can also be done with a 3:1 or 4:1 ratio, but 2:1 is the most common.

This trade is entered 1) when there is a conviction on a downward move but timing is not completely clear; 2) when the cost of a straight put spread is relatively high compared to the profit potential; or both, so the trader wants to commit limited or no capital.

Often these trades can be entered for a credit. The strikes are chosen to maximize the potential profit against gaining the most protection from the short puts. This is where the split ratio can be a great aid by gaining better protection from being put the stock, by selling a put further down in support of the stock.

The maximum gain is the difference between the long and short put, just like a normal put spread, and in a split ratio, it is retained all the way until the lower-strike sold put, where it starts to tail off dollar for dollar with the stock price. Since it is net-short a put, it requires margin and exposes you to owning the stock on a close below the lowest-strike sold put. But, if you are put the stock, it will be at a basis that is reduced by the profit from the initial put spread.

Confusing? Let’s look at an example from a trade we took recently on Salesforce.com (CRM).

Last Thursday (Nov. 17), CRM was looking a bit tired heading into earnings that night. The daily chart below from mid-day showed another bounce off of the resistance area at $138.50 earlier in the week and a couple of long red candles since.

The Relative Strength Index (RSI) was muddling along at the mid line and the Moving Average Convergence Divergence (MACD) indicator was negative, but barely.

There is a slight bias to the downside from this time frame. Support lower comes at $126.75 and then $123, followed by $120 and $117.50, $112, and $110.00.

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NEXT: Key Resistance Levels; Trade Idea to Profit

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Resistance now comes at $130.10, $133, and $135 before the $138.50 area and $143, followed by $147 after that. The weekly chart (not shown) presented the shorter simple moving averages (SMAs) rolling lower with a break below $130.80, a 200% retracement from 2008, and showed the significance of the $110 level as 161.8% of that move.

The RSI on that time frame had risen back to the mid line but stalled (still bearish) and the MACD has stalled, as it made it back to zero. The Options board favored the downside with the put/call ratio at 1.46 overall and near 3:1 on the November 18 expiry.

The at-the-money straddle suggested a move of $13, or just over 10%, creating a range of $116-$141 expected by Friday, with implied volatility at over 200% compared to historical at 46% and December at 76%. Bearish plays were in order.

Trade Idea: Buy November 125/120-110 1×2 Put Spread

Buy the 125 put and sell both the 120 put and the 110 put. This exposes you to owning the stock on a close below $110 with a basis of $105, 18% below the current price of $128.05. It was available for 15 cents near midday.

The key to this trade was the support at $110 allowing the sale of the 110 put and the purchase of the 125/120 put spread, combining to the 125/120-110 split ratio put spread.

This stock did move lower, touching $110.81 before bouncing in the afterhours market and closing at $117.99. That Friday morning, it had been flirting with the $120 level.

Shortly after the market opened, I sold the spread combinations for $4.45, earning a profit of $4.30 and a great end to the week.

By Greg Harmon of Dragonfly Capital

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