The Ratio Vertical Spread
Last week I discussed one of my favorite types of trades, the Backspread. This week, 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 trader would have on a Ratio Vertical Spread. Obviously, those traders would have very different opinions as to the market at that particular point in 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 there are some nice profits to be made.
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 due to the fact that 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 I've mentioned in previous articles, 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. Since 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, and
the Oct 50 Put @ $2.80 with a delta of -29, and
the Oct 55 Put @ $4.10 with a delta of -46.
If we sell 30 of the 50's and buy 20 of the 55's, 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. Try it and if you have trouble just send me an email.
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:
1) There is limited gain potential on the upside.
2) There is the possibility of a huge loss on the downside. (It would be unlimited, but the stock cannot go below 0.)
3) 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 since 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 – Since 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 in the value of the spread initially. However, since the gamma of the position is negative, we want the price of the stock to not move very much.
Time – This position has positive theta, so time is working for you. To get the maximum benefit from the theta you probably would 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.
So 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 far as 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 upside. I am sure that if not for the unlimited downside risk and the large margin requirement, this would be a more commonly used strategy.
As always, if you have any questions about my articles, have suggestions for future topics, or want more information about our options mentoring program, feel free to email me at: sfreifeld@tradingacademy.com or call me at: (888) OTA-2580 ext. 2010.
11. Know Thy Options!
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Stan Freifeld comes to us from the Floor of the American Stock Exchange where he traded options for his own account from 1994-2001. He was a Market Maker for the options on several popular equities including Dupont, Schering Plough, Walgreen's, CBS, U.S. Surgical and Biovail.When he is not trading or thinking about trading, Stan relieves his stress by playing competitive squash, competing in local road rallies with his Ferrari Cabriolet and tutoring local high school students for the SAT's. The bottom line is that Stan, a long time MENSA member, is an engaging teacher with an extraordinary background in options trading and risk management. He is helpful and patient by nature and equally at ease with all levels of traders, from complete novices to advanced pros and academics. He'll be happy to teach you to trade!