Advanced Option Trading: Ratio Spreads

05/25/2012 7:00 am EST

Focus: OPTIONS

Josip Causic

Instructor, Online Trading Academy

Ratio spreads are largely intended only for experienced traders, writes Josip Causic, discussing the composition, profit potential, risk profile, and cost-related items that accompany this advanced option strategy.

Lately, I have been bombarded with questions about ratio spreads from new traders. Let’s start out with explaining a call ratio spread. Though it’s not my favorite option trading strategy because it involves selling uncovered calls, there are indeed times that it can be profitable.

A ratio spread is a combination of a larger quantity of short, deep out-of-the-money (OTM) options, and long OTM options at a different strike price. The premium taken in for selling a larger quantity of short, deep OTM options occasionally is greater than the premium paid for the long OTM options, thus creating a credit. Typically, however, an option trader of ratio spreads ends up with a small debit.  

Multi-legged options have contract fees for each and every single leg, which can add up and eat away into any potential return. The goal is to select a broker that does not charge an outdated ticket fee on top of existing fees per option contract. Option traders should look for the most economical way to trade when it comes to brokerage fees, commissions, and ticket charges.

Let us look in detail at a possible ratio call spread. This particular advanced option strategy is known at different brokerage houses by different names; for instance, ratio vertical spread with calls, or call front spreads.

Regardless of the different labels for the name, the spread is built with calls that are disproportionate in quantity and in the same expiration. Namely, there are more short calls at the higher strike than long calls at the lower strike. If it was the other way around, then we have a completely different strategy which is known by a different name: reverse ratio (call) spread or simply ratio call back spread.

Perhaps in one of my future articles we will go over this and the more practical version of this strategy, the put ratio.

See also: How to Trade Option Ratio Spreads

Let us turn our attention to the composition of a call ratio spread. The set up is done in such a way that we purchase a single contract at a lower strike price and sell two contacts at a higher strike. To visualize it in our minds, think of a stock trading at $47 and the $50 level being a really strong level of resistance.  

Buying an OTM bull call spread involving a long, lower $49 strike price call and selling the higher $50 strike price call would closely match what this call ratio spread is…with the one exception: an additional 50 call is sold so the extra premium can offset the cost of the 49 call.  

The figure below gives a visual of that trade:

chart
Click to Enlarge

To figure out the net credit, we need to multiply $1.50 by two contracts sold, bringing in $3 from which $2.50 must be subtracted. The net credit is $0.50 per share or $50 per contract. This net credit should be viewed as a minimum profit.  

The calculation for maximum profit is a bit more elaborate because it takes into consideration the strike price spread. The formula for max profit is the number of long contracts multiplied by the strike price difference plus the net credit. In our example, the number of 49 calls is only one, and the difference between the strike price spread is also one, while the credit per share is $0.50, so: 1 x (50c-49c) +$0.50 = 1 x $1.50 = $1.50.

The maximum profit takes place at the expiry if both short 50 calls expire worthless and the long call is closed for profit because it is in the money; specifically if XYZ was $49.99 at expiry.

Nevertheless, as attractive as the max profit seems, keep in mind that the selling of the two calls gives the obligation to sell the stock at the 50 strike price. Only one of those two sold calls is covered; the second sold 50 call is uncovered, exposing the trader to theoretically unlimited risk.

If the price were to rally from $47 up and beyond $50—and abnormal moves do happen—then action needs to be taken. The goal was to see the stock price close below $50. Hence, the stock could go slightly up, from $47 to $49.99, remain unchanged, or fall and the net premium received ($0.50) stays the same. Any strong bullish move above $50 could result in losses.  

Also, if a trader is not approved for trading uncovered calls then most likely this type of trade will get rejected by the broker even before it gets executed.

The call ratio spread is an advanced option strategy that is not suitable for novice traders for it requires the approval for trading uncovered calls. One of the ways that the professionals utilize this strategy is by trading it with index options that are European style. Fluctuations in an index historically have not been as volatile as in individual stocks, especially pharmaceuticals.  

Keep in mind that with options education, there is always another, higher level to learn about, and every successful option trader is continually improving their methods and discipline.

See also: Advanced Double-Diagonal Option Trading

By Josip Causic, instructor, Online Trading Academy

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