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Ratio Spreads Part III. Break-even

I believe it's best to trade positions based on current risk and to ignore prices at which your trade becomes a break-even proposition.

Nevertheless, I recognize that most traders are always interested in break-even prices for their positions.  With that in mind, Let's look at ratio spreads and discover how to calculate those break even prices.  This post is primarily for option rookies, especially those who have avoided the temptation to sell extra (naked short) options.

The ratio spread (Part I, Part II) is designed to earn a good profit when the underlying trades within a price range, and it's advantageous when the underlying moves somewhat higher or lower. However, there's always a limit to how far the underlying can move before a profitable situation becomes risky to hold.  A continued move turns the position into a monetary loser.  The worst part of trading these positions is defending against the essentially unlimited losses that are possible. [To eliminate the chance for incurring large losses, the broken-wing butterfly spread can come to the rescue.  That's the topic for part IV in this series]

 

Break-even for 'non-risky side' of the trade

When you trade a call ratio spread, the position contains one or more naked call options.  Risk is to the upside and there is essentially no downside risk.

When you trade a put ratio spread, the position contains one or more naked put options. Risk is to the downside and there is essentially no upside risk.

When the initial position is established, there are three possibilities:

  • A cash credit is collected
  • The trade is made at 'even -money'.' and no cash is required to make the trade
  • A cash debit is paid

When cash is collected, there is no chance to lose money when the stock moves to the 'non-risky' side.  Here is an example.

XYZ is trading near $92 per share

Buy 5 XYZ Jan 95 calls @ $4.00

Sell 9 XYX Jan 100 calls @ $2.30  (Note: the long/short ratio does not have to be an integer)

Net cash:  Collect $70

Risk: 

  • Downside: No matter how far XYZ falls, there is no risk of loss.  The options eventually become worthless, but that $70 premium is yours to keep
  • NOTE: When a cash debit is paid to open the ratio spread, that debit represents the maximum possible loss when the stock moves to the 'non-risky side.'  Most traders prefer to collect a cash credit for ratio spreads – and the idea of a guaranteed profit when the underlying moves in one direction is the rationale behind that strategy.

Break-even for risky side of the trade

  • Upside:  Because you are short four extra calls, there is an expiration price at which this position begins to lose money.
  •  The position shows a real loss at a much lower price prior to expiration because the nine short options carry more  time premium than the five long options.  Clarification:  As the stock rises, the nine Jan 100 calls collectively increase in value more quickly than the five Jan 95 calls (the total position is short delta).  This only happens when you are net short calls.  Individually, the Jan 100 calls never increase more rapidly than the Jan 95 calls.  But when short extras, there is upside risk.

Recognizing that there is an upside price beyond which this ratio spread loses money, the objective is to calculate that price.  NOTE:  This discussion involves finding the break-even price at expiration.

Method A (I find this method to be much easier)

You own 5 XYZ Jan 95/100 call spreads.  Above 100, these are worth $500 apiece, or $2,500.

You collected $70 cash to open the trade

Thus, you have a profit of $2,570 when XYZ is $100 at expiration.

You are short four extra calls

You lose money at the rate of $400 per point when XYZ moves above $100

Divide the meximum profit ($2,570) by $400.  Result: $6.425

That tells you how far the stock can rise (beyond $100) to reach the break-even point.

Result:  Upside break-even point for this trade (ignoring commissions) is $106.425

 

Method B (Algebra)

For the trade to be a break-even, the value of the longs and shorts must be the same.

Let X = the option value that represents the break-even price.  At that price, each of your long calls is worth $500 more than each of the short calls.

5*(X+500) +70 = 9X
5X + 2,500 +70 = 9X
2,570 = 4X
X = 642.5

The option 'value' above $100 is $642.50, or $6.425 per share.

B/E = $106.425

I understand how important it is for most traders to recognize the break-even prices for a position such as the ratio spread.  However, by focusing on these price points, it's easy for a trader to fall into the trap of believing that as long as the stock trades within those prices (in this example that's between 0 and $106.42) that all is well and that the trade is under control.

That is false security.  There is no risk on a market decline (when it's a ratio call spread that generated a cash credit), but there is upside risk that comes into play well before the expiration break-even price is reached.  Just think of the risk when XYZ is trading near $106.00 two weeks before expiration.  It's more important to manage current risk and to be certain your comfort zone boundaries are not violated than to ignore risk and gain comfort that the position is still below the break-even price..

Ratio spreads work well in the hands of traders who understand how to limit damage when the underlying moves too far.  Concentrating on expiation break even is exactly the same as looking at naked short options, hoping they expire worthless.  In this example, the strike price of the extra options is $106.42.  Losses accrue well below that price prior to expiration.  It's just as risky to 'hope' XYZ finishes below that price as it is to hope that short options expire worthless. 

If the potential losses of ratio spreads are of concern (they should be), next time we'll look at methods for capping those losses at acceptable levels. [It must be acceptable by definition because you get to choose the maximum potential loss.]

to be continued…

842

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Ratio spreads. Part II

Taking a few days off . Plan to return Monday.

Happy Thanksgiving holiday to all.  Let's remember the good things in our lives


Yesterday I introduced the topic of ratio spreads.  Today let's look at some risk graphs and discuss the reasons for trading these spreads.  It's a very appealing strategy and has a lot to recommend it.  However, potential losses prevents this idea from being in the trading arsenal of the more conservative options trader.  Also, it should be avoided by inexperienced traders.

Let's take a typical situation.  You anticipate a market rally (or fall) over the near term.  Nothing major.  Perhaps 3-5%.  You want to make a trade that makes a decent profit if your prediction comes true, and are willing to lose money when you are wrong.

SPY is currently 120 (as I write).  Your expectation is that SPY may rally towards 125 by December expiration.  The question is, how to play. 

There are many choices.  The most basic play is to buy calls, choosing an appropriate strike.  This is unattractive to some traders because the options may be priced too high or time decay may become too rapid.  Alternatives include selling OTM puts and put spreads or buying calendars etc.  However this discussion is focused on ratio spreads and how to use them.

Each of those ideas has its good and bad points, and choosing a trading strategy is as much about market expectations as it is about the trader's individual comfort zone.  Even when positions are known to produce identical results (equivalent positions), some traders are more comfortable when trading one strategy rather than another.  We may all know that the results are the same, but if one type of trade makes you feel better, or helps you analyze the position with less effort, then it's better to choose that trading strategy.

Buy Call Spread

Choosing the specific option to buy is a discussion all by itself.  However, let's assume that you have confidence in your expectations and buy SPX Dec 121/126 call spreads, paying $1.30 per spread (pay $1.62, sell at $0.32).  The risk graph (figure 1; the thick line represents P/L at expiration and the thin line shows P/L for today.) is as anticipated for a bullish spread.  Thus, profits increase as the market rises, but reach a limit.

With a simple call spread, you earn the maximum possible profit when the market rallies and both calls are in the money when expiration arrives.

 

The ratio spread

If you want to take extra risk to generate extra cash, instead of making a simple bullish play (buy call spread), you decide to sell extra calls.

If you have the confidence (or simply want to place the bet) that the market move will occur – but will be limited in scope, then the ratio spread can be advantageous.

In this example, let's sell one extra Dec 126 call for each debit spread bought.  That means you will be short two Dec 126 calls for each Dec 121 call owned.  Your anticipation is that those 126 calls will expire worthless and backing that belief, you are willing to sell the extra call and collect an extra $32 in premium. [This is a fairly small premium, considering the upside risk.  But that discussion is for a later date]

This play is not simply a matter of selling extra calls and cashing the check.  Risk of loss is real. If you are not sure why this is true, it's too early in your options education to be trading ratio spreads.  Risk is discussed below, but if this idea is new to you, it is better to avoid this play until you are better prepared to handle the risk management aspect of this strategy. Take a look at figure 2, which represents the profit/loss picture for the ratio spread.

The red lines represent the ratio spread while the blue line still traces the P/L profile for the debit spread.

Whereas profits are never threatened when SPY rallies in figure 1, figure 2 illustrates a very different story.  At expiration, profits reach their maximum when SPY is 126.  However, what makes this trade so different from the simple debit spread is the rate at which those profits can disappear when SPY moves above 126. In fact, the graph indicates that all profits disappear when SPY reaches 130.

Let's consider why this is true.  Your ratio spread consists of two separate positions: the debit spread and the naked short call.  When you made this trade, you paid a debit of $98 per spread. [Paid $1.62 and collected 2 x $32].  When the market moves lower, that $98 represents the maximum possible loss.  This is illustrated by the horizontal red line when SPY is below $121.

When SPY rallies and reaches $126 (at expiration), the Dec 121/126 call spread reaches its maximum value of $5.00.

However, you are short one naked call option – and that's the Dec 126 call.  The value of this option increases by $1.00 for every point that SPY rises.  When SPY is $130, it is worth $4.00.  That leaves you with a position worth $1.00.  When you subtract the $98 that it cost to initiate the position, your proit has disappeared (OK, you have $2 before commissions).

If SPY continues to rise, your idea to own a bullish position has backfired because you underestimated the size of the move.

Tradeoff

That's the tradeoff.  In return for collecting a higher cash premium, you accept the risk of being short one naked option.  When that option moves into the money, it threatens to reduce, and then take away all profits.  And if SPY moves higher, losses mount at the rate of $100 per point.

to be continued…

840

 

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Ratio spreads. Part I

There are several commonly used option strategies that never get mentioned at Options for Rookies.  I have my reasons for ignoring those strategies.  However, because this is an options education blog, it's worthwhile to describe some of these methods, explain the pros and cons of using them, and each reader can judge whether such strategies are appropriate.

One such strategy is the ratio spread.  It is sometimes referred to as a 'front spread' because it is the direct opposite of a back spread.

Ratio Spread

This term can have a broad or more narrow definition.  It's the narrow definition that is used most frequently:

Broad definition: A ratio spread is any option strategy in which the trader sells more options than he/she buys. 

The more limiting definition includes: Similar to a vertical spread, all options are on the same underlying stock or index and have the same expiration date.  Only the strike price differs.  The options sold always have a smaller delta than the options bought.

Many times the ratio spread is initiated as a delta neutral position.  However, when you are trading with a market bias, you may prefer to select specific options and a specific ratio to suit your market expectations (more on that tomorrow).  Let's look at examples.

Note:  The following are randomly chosen spreads and are not recommendations.  I will not be trading any of these examples for my own account.

Example.  Ratio call spread

Buy 1 AAPL Jan 330 Call
Sell 2 AAPL Jan 350 Calls

This is referred to as a "1 X 2 call spread,"  with 'X' being used to represent the word 'by.'

As I write this (Nov 18, after the market close), AAPL is 308.43 and the estimated execution prices for this trade are $6.60 and $2.70.  The trader pays $6.60 for the call purchased and collects $2.70 for each call ($5.40 total) sold.  Thus, the cost to buy this position is $1.20.  As with any other options trade, that $1.20 is per share and the true cost is $120.

The total description of this trade is: "The trader bought the Jan APPL 330/350 1 x 2 call ratio spread at a net debit of $1.20"

IMPORTANT NOTE: If you describe this trade verbally, especially when entering the order through your broker, you MUST use the lowest common denominator for the ratio. 

In other words, if you enter this trade 20 x 40, the terminology is: "Buy 20 1 x 2 spreads at a net debit of one dollar and twenty cents for each 1 by 2."   Never, tell the broker that this is a total debit of $2,400 ($120 * 20).

Example.  Ratio put spread

Buy 2 AAPL Jan 270 Puts @ $7.10
Sell 3 AAPL Jan 260 Puts @ $5.20

This is a "Jan AAPL 270/260 2 by 3 put ratio spread at a net credit of $1.40"
This position is initiated with the trader collecting a cash credit of $140.

What's the Problem?

There is nothing truly 'wrong with spreads of this type, and experienced traders use them as part of their trading arsenal.  The main reason that I don't discuss ratio spreads is because they are positions in which you would be 'net short' options.  These are referred to as 'naked' shorts.

Many brokerage firms do not allow any of their customers to own positions with naked call options.  Others allow experienced traders to sell naked puts and calls.  Thus, some of you would be limited in your ability to trade this type of position, depending on the whim of your broker.

Risk Management.  That's the problem.  The major focus of this blog is to help rookie option traders learn to trade options successfully.  To do that, it's very important to recognize, and control, risk – in the form of 'how much money can I lose on this trade in the worst case scenario?'  Naked short positions make it impossible to gauge a worst case (for calls) and it bcomes difficult to keep a handle on current risk.

When short naked options, the loss is theoretically unlimited for calls and the value of the strike price (x 100) for puts.  In reality those extremes do not occur.  Yet, gigantic losses are possible.  That's why I never suggest that rookie option traders ever hold positions that are naked short any call options.  I make one exception for holding naked put options: If you want to accumulate stock positions for your portfolio, one acceptable method for attempting to do that is to sell naked put options.

The combination of

  • Horrific results are unlikely but possible
  • In general, brokers do not allow inexperienced traders to sell naked options
  • I believe that it takes a good deal of experience before considering selling naked options
  • I never sell them myself (simply because margin requirements are too high)

puts me on record for not recommending these trades to my audience of rookie traders.  Many experienced traders can handle  these spreads because they have seen what the market can do.  I assume that any trader who has been in the game long enough to have gained significant experience, survived because he/she already understands the importance of manageing risk. [That's my way of saying that traders who ignore risk will not survive very long]

Broken Wing Butterfly (BWB)

One other possibility for limiting risk and making the ratio spread a viable alternative is to buy one extra call or put option for each option sold.  In other words, there are no longer any naked shorts.  That option

  • Is farther OTM than the short options
  • Provides ultimate protection by 
    • Limiting losses
    • Reducing margin requirments
    • Creating a position that all brokers will accept

This new position is known as a butterfly spread – if the options owned are equally distant from the options sold:

Butterfly example:

Buy one AAPL Jan 330 call
Sell two AAPL Jan 350 calls
Buy one AAPL Jan 370 call

In most scenarios, the option bought is farther OTM and the distances are unequal. That new position is called a broken wing butterfly and is the position typically adopted by more conservative traders who want to trade ratio spreads.

Broken Wing Butterfly (BWB) Example:

Buy one AAPL 380 (or higher strike) call – instead of buying the Jan 370 call.

I'll have more to say about BWBs later in this series.

Next time I'll discuss the risk profile for ratio spreads and how your market outlook plays a role in choosing strike prices when trading ratio spreads.

to be continued

839

 

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