By Stan Freifeld, a market maker for options on several popular equities*
Posted: Sep 4, 2009
In the article titled "Two Sides of a Trade: Part 1 of 2, Benefit with Backspreads", I discussed one of my favorite types of trades, the backspread. In this article, I’m going to talk about the other side of that trade, the ratio vertical spread.
In other words, if two traders were trading with each other and one put on a backspread, the other would have a ratio vertical spread on. Obviously, these traders would have very different opinions as to the market at that particular time.
To be honest, I'm not a great fan of this type of spread, but I want to give you a sense of how to look at the other side of a trade. Also, occasionally, this trade does set up nicely, and when it does, you can make some nice profits.
Once again, let's start off with a definition:
Definition: A ratio vertical spread is a delta neutral options position that consists of more short options than long options on the same underlying stock. It can be established with either calls or puts in the same expiration month and is sometimes just referred to as a ratio call spread or a ratio put spread, respectively.
There is also a calendar or diagonal ratio vertical spread, which has more options being sold in a far month than are being bought in a near month. These spreads are not very popular because the margin requirements are quite large. This is because the long options would expire before the shorts, and therefore, the shorts are not covered for margin purposes and are considered to be naked.
As mentioned in Part 1 of this article, since the crash of 1987, most indexes and many stocks trade with a reverse or negative vertical skew. That means that OTM puts will generally trade with a higher implied volatility (IV) than OTM calls. This implies that we should sell the lower strike and buy the higher strike. Because we want to make the spread delta neutral, it will set up much better with puts than with calls.
To make a ratio vertical spread delta neutral, the ratio of short to long options is usually somewhere in the neighborhood of 2:1 or 3:2. Ratios greater than 3:1 should be avoided.
Let's look at an example of a ratio put spread, with:
- XYZ @ $55.30
- The Oct 50 Put @ $2.80 with a delta of -29
- The Oct 55 Put @ $4.10 with a delta of -46
If we sell 30 of the 50s and buy 20 of the 55s, we’ll have a position that is net short 50 deltas, which is close enough to be considered delta neutral.
It's calculated as follows: -30 x -29 + 20 x -46 = -50. Of course, if you’re really a stickler, you could have used a ratio of 30 to 19, which would have produced a delta of only -4.
Now that's neutral!
Also note that the net cost of putting on this position is a credit of $200, calculated as -30 x $280 + 20 x $410 = -$200.
At expiration, the graph of this position will look like this:
(For practice, you might want to try drawing a graph of a ratio call spread.)
It is very important to be able to draw these graphs because a number of characteristics of the spreads become apparent just by looking. In this case, we can immediately see:
- There is limited gain potential on the up side.
- There is the possibility of a huge loss on the down side. (It would be unlimited, but the stock cannot go below 0.)
- The best place for the stock to end up at expiration is where the 2 diagonal lines meet, which is the strike price of the short options.
The maximum value of this position at expiration is at a stock price of $50. At that point, the 55 put is worth $5, but because it cost $4.10, the profit is 20 x (5 – 4.10) x 100 = $1,800.
In addition, the 50 put is worthless, but we took in a credit of $2.80, so the profit on that option is 30 x 2.80 x 100 = $8,400. The total profit is, therefore, $10,200. As the stock declines from that point, the position will lose $1,000 for each $1 move. So, when the stock moves down 10.2 points to $39.80, the entire profit will be eliminated. Further declines will result in an overall loss.
On the other hand, if the stock price increases from $50, the value of the position will lose $2,000 for each $1 move. When it gets to $55, the position will have a small profit of $200, which is the amount of the original credit taken in. Above $55, both options become worthless, so the profit on the position is just the original credit of $200.
Let's look at the Greeks and see what else we can determine about this type of spread:
Price -- Because the position was put on delta neutral, we know a small move up or down in the price of the stock should not have much of an impact on the value of the spread initially. However, because the gamma of the position is negative, we want the price of the stock not to move very much.
Time -- This position has positive theta, so time is working for you. To get the maximum benefit from the theta, you would probably want to put this position on within 60 days or less to expiration.
Volatility -- This position has negative vega, so a decrease in IV is helpful, which implies that it should be put on when volatility is high and expected to come in.
We see that a ratio put spread is used when there is a reverse vertical skew and volatility is high and expected to return to normal levels. For maximum results, the options that are sold are at the strike price of where you think the stock will be at expiration. The long options should be a strike or 2 higher than that.
As to which expiration month to choose: You could use either the current front month or the one following. If you’re able to put the position on for a small credit or even a small debit, there’s no risk to the up side. I am sure that, if not for the unlimited downside risk and the large margin requirement, this would be a more commonly used strategy.
*Reprinted (and modified) with permission from Online Trading Academy (www.onlinetradingacademy.com). Stan Freifeld can be reached at: sfreifeld@tradingacademy.com.
