Ratio Spread Strategy

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Dylan Sanders
6 years ago
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Ratio Spread Strategy GOAL To defray part or all of the cost of trading a market with options by purchasing and selling options simultaneously in the same contract month.

1 Ratio Spread Strategy GOAL To defray part or all of the cost of trading a market with options by purchasing and selling options simultaneously in the same contract month. SUMMARY We purchase one option close-to-the-money and sell two farther-out-of-the-money options within the same contract month, in the same direction (i.e., all call options, or all put options). The Option Ratio Spread works especially well when used in conjunction with the Hi-Lo Breakout Strategy, but can also be used along with any of the other chart patterns found in the GBE Course manual. Also be aware that the Option Ratio Spread works best in advancing markets, although it can be used in declining markets as well. Trade options with at least 45 days remaining prior to expiration. One of the strengths of the Option Ratio Spread is that it can be profitable whether the market moves as expected, remains neutral, or even if it moves against us. CHAPTER ONE STEP-BY-STEP INSTRUCTIONS 1 Identify a market that has just made a quick move in the direction you want to trade. (Again, consider trading this strategy in conjunction with the Hi-Lo Breakout Strategy, which also relies on a spike in prices for entry. The spike can be up or down.) For our example we ll use the December 2008 Corn market. Examine the chart and notice the sharply rising price action out of the pennant formation during the first part of June.

Trend Seeker s trend rating must be up to initiate a ratio spread with call options.

2 Note: To ensure you re seeing as much historical price data on the chart as you need, scroll below the chart, select the 1024 x 768 (large) option, and click the Resize This Chart button 2 Confirm the direction of the trend using Trend Seeker. Trend Seeker s trend rating must be up to initiate a ratio spread with call options. It must be down to initiate a ratio spread with put options. Phone Toll-Free Fax The Greatest Business on EarthTM

3 Purchase one option that is close-to-the-money while simultaneously selling two options that are farther-out-of-the-money in the same contract month.

3 3 Purchase one option that is close-to-the-money while simultaneously selling two options that are farther-out-of-the-money in the same contract month. In an advancing market, you would buy one call option close-to-the-money and sell two call options farther-out-of-the-money. In a declining market you would buy one put option close-to-the-money and sell two put options farther-out-of-themoney. The premium collected from selling the farther-out-of-the-money options should cover all or a good part of the premium of the closer-to-the-money option purchased. As an example, let s say we look at our charts on June 3 and notice that December Corn futures broke out of a pennant formation the day before, triggering a paper trade to the upside (see Daily chart above). Futures prices closed that day at Based on our chart analysis and the Trend Seeker trend direction, we expect prices to continue to rise. To establish an Option Ratio Spread, we might purchase one December 730 call option and simultaneously sell two December 830 call options. Suppose that on the day we enter the market (June 3), the premium for the 730 call is 38-6 cents, and the premium for the 830 call is 20-7 cents. One cent in the Corn market is $50. Therefore, we would pay $1, for the 730 call option (38.75 cents x $50/cent = $1,937.50), while we receive $2, from the sale of the two 830 call options ( cents x 2 options x $50/cent = $2,087.50).

4 In this example, we receive $150 more for the options we sell than we invest in the option we purchase. This is termed a credit spread of 3 cents (3 x $50/cent = $150) before subtracting commissions and exchange fees. Now we enter the trade into Trade Tracker to follow its progress. Notice the quantity and position for each option input into Trade Tracker. The first trade listed is for the purchase of one option; because it was a purchase, we are long this option. The next trade listed is for the sale of two options. We are technically short these options so we select short when inputting these options into Trade Tracker. Also note that commissions have an effect on the profit/loss.

4 Watch the market closely to determine when changing market conditions indicate it is time to liquidate all or part of the position (see Possible Exit Strategies below).

5 4 Watch the market closely to determine when changing market conditions indicate it is time to liquidate all or part of the position (see Possible Exit Strategies below). This is important because while there are many advantages to using this strategy, you want to avoid the situation described in the following section. CHAPTER TWO POSSIBLE EXIT STRATEGIES In a Market Moving in Our Favor As futures prices enter the range between the strike prices for the option bought and the options sold, our now in-the-money option begins earning intrinsic value, while the two options we sold remain outof-the-money and are losing time-value; therefore they are not a threat at this time. The best-case scenario for the Option Ratio Spread is for the futures price to get as close as possible to without exceeding the strike price of the options we sold before expiration. This will give us the maximum profit on the option we bought, and the two options we sold will expire worthless; we get to keep all the premium we sold them for, and will have no further responsibility. There is only one instance in which the Ratio Spread can run into difficulty. It s when the price of the underlying futures market exceeds the price of the options we sold (wrote). For example, in our sample trade, if December Corn expires at 830 we make a 100-cent profit, multiplied by $50 a cent, for a total of $5,000. However, if December Corn exceeds 830 we begin to lose $50 of our profit for every penny that Corn exceeds that price. As a result, we would lose all our profit, and just break even on the trade if the underlying futures price continues to rally up to 930, and would have a net loss of $50 for each cent Corn exceeds the price of 930.

6 To protect our capital and reduce the possibility of a large loss in this type of situation, we should completely close out of all of the options we initially bought and sold if and when the underlying futures market exceeds the strike price of the options we wrote (of course, please note that market conditions may prevent our orders for liquidation from being executed at our preferred price). Going back to our example, if December Corn rallies to and exceeds 830, we would close out our entire position. Generally we find that if a market rises slowly toward the strike price of the options we sold and begins to exceed it, we may still keep a good portion of profit on the position when we close it out. If the market begins to act strongly and moves sharply higher, many times just closing out one of the two options we sold may be enough to avoid losses, as the increase in our long position will offset the loss in our remaining short position. Only in the unusual case of an extremely rapid rise in the futures price might we find ourselves closing out the entire position at a loss. In a Market Moving Against Us or That Doesn t Move at All If prices go contrary to our plan, we simply hold on to the position and at expiration all of the options will expire worthless, but we ll still have all of the premium we received when we initiated the trade. Thus, even though the market may act exactly opposite to our analysis, we still can make a profit. CHAPTER THREE SAMPLE TRADE If the December Corn market rises as we expect, we will receive a profit of $50 for every penny December Corn rises between 730 and 830 before expiration, for a maximum profit potential of $5,000 (the difference between the 730 and 830 strike prices or $1.00 x.50 = $5,000). Phone Toll-Free Fax The Greatest Business on EarthTM

7 CHAPTER FIVE WHEN THIS STRATEGY SHOULD BE USED The best time to initiate an Option Ratio Spread going long is when the futures market has made a quick, straight move up. This type of price action normally increases the demand for out-of-the-money options so we can sell them for a good price. A rapid price move also seems to correspond with the time when there is the greatest disparity in premiums between close-to-the-money options and out-ofthe-money options, which may provide the best opportunity for successful Option Ratio Spread trades. The farther-out-of-the-money we can sell an option, the greater our potential for profits and safety. As mentioned earlier, this strategy works well in conjunction with the Hi-Lo Breakout Strategy. The Option Ratio Spread seems to work best in advancing markets, but it can work in declining markets as well. CHAPTER FIVE POSSIBLE ADVANTAGES OF THIS STRATEGY Here are the benefits of executing this Option Ratio Spread: 1 Unlike a typical option trade, we will have limited or no initial cost for our purchase because the purchased option s premium is paid for in part or completely by the sale of the two options. We may even start out with a small profit, as we did in the Corn example above. 2 If prior to expiration the market moves in the direction we expect, we will receive a profit equivalent to the difference between the strike prices of the option we purchased and the options we sold. Our maximum profit potential will be realized if the futures price reaches but does not exceed the strike price of the options we sold. 3 By entering into this position, we are taking advantage of the disparity in strike prices between the premiums of the option we bought and the ones we sold. In many markets, options closer-to-themoney have less volatility because they are not as much in demand as the cheaper, farther-outof-the-money options. This demand for the generally more affordable out-of-the-money options usually results in their premiums being overpriced. These options the ones with artificially inflated premiums are the kind we want to sell. These options will also lose their time value the most quickly as the market nears expiration. Take a look at the chart below. It displays how dramatically time value decreases for options as they approach expiration.

8 CHAPTER SIX POSSIBLE DRAWBACKS 1 As described above, there is one situation where an option ratio spread can lead to trouble: when the price of the futures contract exceeds the strike price of the options we sold. To help protect ourselves from the potential for unlimited losses, we can close out the Option Ratio Spread if the futures price exceeds the strike price of the options we sold. 2 Another drawback of this strategy is that unlike some option trades, where the profit potential is unlimited, the potential profit with this strategy is limited to the difference between the strike prices of the option bought and the options sold. 3 Also, be aware that you will need to keep margin money in your account to trade this strategy because you are selling one more option than you are buying. The margin required is typically the futures requirement, minus the credit or premium you take in. Most of the time the margin you are required to put up is based on the SPAN margin system. This typically means the brokerage firm will adjust the margin as needed, based on the volatility of the underlying futures contract and the amount the option is out-of-the-money. Be sure to paper trade this strategy to discover whether the Option Ratio Spread is right for you! Notice: Being a successful PAPER TRADER during one time period does not mean that you will make money when you actually invest during a later time period. Market conditions constantly change. When granting options, you may lose more than the funds you invested. Option spread strategies do not necessarily limit your risk of loss. Simulated performance results have certain inherent limitations and do not represent actual trading. No representation is being made that any account will or is likely

9 to achieve profits or losses similar to those shown. This brief statement cannot disclose all the risks and other significant aspects of the commodity markets. You should carefully study commodity trading and consider whether such trading is suitable for you in light of your circumstances and financial resources before you trade. WARNING: FUTURES AND OPTIONS trading involves high risks and YOU can LOSE a lot of money.

The Synthetic Futures Position. Goal

The Synthetic Futures Position Goal To try to profit from a trending market using an option strategy that allows entry at a reduced cost while offering the same potential for unlimited profit (and loss)