Liberty Trading Group Introducing The Ratio Credit Spread For More Protection

arkets, or markets with the potential to become volatile, option sellers often look for a layer of extra protection to cover their downside risk just in case. An effective tool for accomplishing this goal in an Option Selling Portfolio is the Ratio Spread.

Also known as a ratio credit spread, this is a strategy that offers a layer of protection while also the ability to profit more if the market moves against ones short options. While there are many complex, mathematical, delta neutral explanations available for ratio credit spreads, the basic concept is not difficult to understand. A ratio credit spread is really just selling a group of out of the money naked options, and then adding one final twist: After selling the naked options, the trader takes part of the premium collected and buys a close to, or at the money option. The premium left over after the purchase of this additional option is called the credit. The number of options sold vs. the amount purchased is the ratio. Thus if you sold four options for every option that you purchased, the ratio would be 4:1. In a credit spread, if all of the options involved expire worthless, the traders profit will be the net credit he received from the option sale, after purchasing the at the money option(s) and paying transaction costs.

Benefits of Using a Ratio Credit Spread

What are the benefits of purchasing this additional option as opposed to simply selling naked?

The benefits are threefold:

1. By purchasing a near or at the money option, a trader adds a strong layer of protection to his short option position. The long option covers, at least partially, the short option position. Therefore, in volatile markets, a move against the short option position will be at least partially offset by a profit in the long option position. And as a move against a naked short option position can mean increasing margin requirements to the holder of those positions, a profitable long option will also minimize, if not entirely offset this margin increase. Therefore, to the trader, a credit spread can bring a much more stabilizing effect to an account with smaller swings in equity and margin requirements in adverse market conditions. Thus, buying a close to the money option to counteract out of the money short options can be termed buying protection by short option sellers.

2. The second benefit of a credit spread is the opportunity it offers for increased profits over and above the profit collected from the short options. If the price of the underlying contract is somewhere between the strike of the long option and the short options at expiration, a trader profits not only from the premium collected on the short options, but also from the long option expiring in the money. Depending on how far in the money it is at expiration, profits from the long option can range from minimal to substantial.

3. Staying power. Because of the offsetting effect this long option has on short option values and margins, it allows to trader to withstand wide adverse moves against the position, even more so than selling far out of the money naked options. Therefore, if the trader is ultimately correct in his longer term projection for prices, he can withstand a large degree of short term price fluctuation while remaining in the trade and allowing the market enough time to make the position profitable. This is highly important in volatile markets.

At some point, of course, in an adverse market move, the losses from the short options will begin to exceed the rate at which the long option can counterbalance them. This loss rate is maximized once the short options go in the money (if the trader holds the position that long). However, the losses would be smaller and accrue more slowly than they would if the options were simply sold naked.

There are many variations to credit spreads. There is no one, correct formula for how many options to sell vs. how many to buy. However, trading the spread more aggressively generally means collected a larger credit and buying less protection. The more conservative approach would mean collecting less of a credit and buying more protection.

EXAMPLE: RATIO CREDIT SPREAD IN COFFEE

A trader who is neutral to bearish the coffee market (looking at the upcoming Brazilian harvest no doubt) wants to sell calls above the market. He elects to sell the September 2.40 Coffee calls because although he is not sure where prices will be in August (option expiration), he feels fairly confident that they will still be below 2.40. The trader sells 4 of these September 2.40 Coffee call options for 100 points ($375) each for a total premium collected of $1500. He then sees the September 210 calls selling for 160 points ($600) each. He takes a portion of the premium he collected from selling the 2.40 calls and buys one September 210 call.

His credit is as follows: $1500 – $600 = $900.

If coffee continues to move lower and all of the options expire worthless, the credit will be the traders profit ($900). If the coffee market moves higher, but remains below $2.40, the profits could be substantially higher.

The Perfect but Less Likely Scenario

For instance, suppose on option expiration day, September coffee is trading at $2.20 per pound. The 2.40 calls would expire worthless ($1500 profit). The 2.10 call would expire 10 cents in the money, meaning it is now worth $3,750. If the cost of purchasing this option ($600) is subtracted, it nets a profit of $3,150. Therefore, the net profit on the trade would be $4,650 ($3,150 + $1500 = $4,650).

Risk and Risk Management of the Ratio Spread

Risks on a ratio credit spread, like futures trading or naked option selling, can be unlimited once the underlying contract exceeds the short option strike price. Although a ratio credit spread can still be profitable above the short option strike price, it is generally a good idea to exit the position after the strike price of the short options is reached. After this level is exceeded, profits can begin to deteriorate and losses can begin to accrue quickly. However, this would happen at a slower pace than would be possible if the options were simply sold naked.

The downside to ratio credit spreading (as opposed to naked option selling) is that profits from the sale of short options are reduced. However, credit spreading can be considered a more conservative strategy than outright naked option selling. The reduced profit margin on the short option sales is a price some traders are willing to pay for the increased protection the credit spread can offer to his short option position.

Ratio credit spreads may not be perfect for every market. Selling naked may be a preferable strategy in some situations for many traders. However, ratio credit spreads can work very well under the right market conditions, which is why they can be a valuable tool in a balanced portfolio.

***The information in this article has been carefully compiled from sources believed to be reliable, but it’s accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss, and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.

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