Ratio spreads were identified by David L. Caplan in "The New Options Advantage" as one of the safest and potentially profitable option trading strategies for traders who want a trading edge over the markets. In this article we wish to discuss a variation of the concept to demonstrate how these trade setups can not only be safe, but given the right conditions, provide a huge return on investment.
Let’s take the following as an example:
Assume we have a bearish outlook for the next couple of months on a popular stock index and wish to take advantage of that using put options. The index is currently trading around 4400 and we decide to do the following. The following options positions all have an expiry date at least 60 days out.
Buy 5 "out of the money" put option contracts – index strike price 4200 – cost $135 each
Sell 15 "further out of the money" put option contracts – index strike price 4000 – income $88 each
Buy 10 "even further out of the money" put option contracts – index strike price 3900 – cost $70.50 each
You can see from the above example, that we have bought and sold the same amount of contracts in total, but since they are at different strike prices and each for a different number of contracts, they qualify to be defined as a "ratio spread". The beauty of the above example is that your overall debit would only be around $600 plus brokerage, but with a potential profit of $9,400 if the market closes at 4000 on expiry date. That is over 1500 percent return on investment!
If we were to graph the trade, we would noticed that the position will make at least some profit if the index closes anywhere between 3900 and 4200 at expiry date, while the maximum profit of $9,400 is achieved at the 4000 level.
A trade with this level of potential profit level at such minimum outlay, being bearish in outlook, can also be used as a hedge against other open trades that may have a bullish outlook. If the current market is uncertain and bad news is floating about such as a ‘global financial crisis’ or ‘recession’ or any international unrest which may affect the confidence of the markets, then a ratio spread of this kind could also be an excellent way to protect yourself against the risk of falling stocks. You could even view it as a form of ‘insurance’.
For any hedge to be effective, it requires minimal outlay to protect yourself against other positions involving much higher investment of overall capital. This kind of ratio spread serves exactly that purpose. It’s all about money management – how you have allocated your overall capital and how much you risk on any one trade.
In summary, ratio spreads can take different forms in terms of how many of each position you buy and sell – i.e. the ratio of ‘buy’ vs ‘sell’ positions and their respective strike prices. As such, they can be used for varying outcomes according to your own personal trading risk profile. If you have a good piece of software that will quickly analyze the risk vs reward ratios as a graph, you can easily assess the value of various combinations to determine the optimal choice for whatever overall option trading strategy you have in mind.
