4 Tips for Trading Ratio Calendar Spreads

11/19/2014 8:00 am EST

Focus: OPTIONS

Michael Thomsett

Founder, Thomsett Publishing Website

Option expert Michael Thomsett of ThomsettOptions.com offers a creative way to cover short risk without the need to own shares of the underlying.

One way to cover a short position is to own 100 shares of the underlying stock. Another, more creative way is to sell a shorter-term expiration position and buy a longer-term position. This works not only with calls, but also with puts.

The calendar spread is a popular strategy; it can be expanded, however, to create a ratio calendar spread. In this twist, you sell more of the shorter-term expirations and you buy fewer of the longer-term expirations. This makes it more likely that the short premium on the first set will pay for the cost of the long positions. Because you end up with more short than long positions, there is risk involved. The higher the ratio, the lower the risk. For example, selling two short options and buying one long is very risky. But selling four short and buying three long is less risky; there is a greater degree of coverage involved.

A ratio calendar spread is not as risky as it appears at first glance, even though one or more of the short positions are naked. This is true because time works in your favor. A few points to keep in mind:

  1. The short options are going to lose time value more rapidly than the long options. This means one or more may be closed at a profit, eliminating the uncovered option risk.
  2. Even if the short positions move in the money, they can still be closed at a profit if and when time decay outpaces intrinsic value. This occurs frequently, especially as expiration approaches.
  3. To avoid exercise, the uncovered portion of the ratio calendar spread can be rolled forward. The ratio calendar spread's risks can be managed by combining time decay with timing of entry (opening short positions when implied volatility is exceptionally high, for example).
  4. The short options have to be accompanied with margin collateral equal to 100% of the strike value. This is a burden, of course, but if you have the cash or securities available, it makes it more manageable.

The most critical point about these strategies is that the short options are going to lose value before the long options, which gives you a great advantage. Even if one of the options is assigned early, the long positions can be applied to satisfy that assignment. All or part of the short side can be closed at any time to eliminate the risk, making the ratio calendar spread a good strategy with less risk than you find in just selling uncovered positions.

By Michael Thomsett of ThomsettOptions.com

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