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Backspreads And Ratio Spreads, Part II

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By Lee Lowell

Let's finish off this session with a discussion of the "ratio spread." As we saw last time with the backspread, the ratio spread also consists of an unequal amount of options. Only this time we'll have more short options than long in our position. The ratio usually occurs in the form of a 1x2 or a 1x3 spread and is executed within the same month. Same as the backspread, the ratio spread could be of a put-type or a call-type. And as I noted last time, I'll show you how to get around the issue of having uncovered short options in the account.

The ratio spread is also classified as a type of volatility spread due to the fact that its success relies on a certain type of option skew. If you're initiating a put ratio spread, you'll buy a put which is usually ATM or OTM, (depending on your preference), and sell 2 or more farther OTM puts. With a call ratio spread, you buy an ATM or OTM call and sell 2 or more further OTM calls. Since we are short more options than long, we want to initiate the spread using near-term options that have little time left. We want very little movement or slow movement towards our short strikes. Contrast this to the backspread, where you are hoping for explosive movement to occur very quickly.

When initiating a put ratio spread, we are looking for a "reverse" volatility skew. This means that the lower-strike options we sell should be trading at a higher implied volatility than our long higher-strike options. In the case of a call ratio spread, we want a "forward" skew which would give the short higher-strike options a higher IV than the long lower-strike options. This ensures us of putting on the spreads in its most favorable conditions. How do you tell if the skews are correct? You need to have some sort of data vendor that supplies this information or you can run the numbers through an option calculator and solve for IV. The easiest way though is through the data feed.

Here's a screen shot of the data feed vendor I'm currently using. This is an option chain for Applied Materials showing the June put contracts. If you look at the last 2 columns on the right which show "Imp Vol(B)" and "Imp Vol(A)", they signify the implied volatility of the options (in percent) based off the actual bid and asked prices respectively. You always want to make sure you see implied volatility numbers based off the bid/ask prices because these are always current. If you look at IV numbers based off the last trade, you may be looking at stale numbers of a trade that could've occurred days ago.

AMAT is showing a reverse skew for these June puts. Just look at the IV numbers and you can see how they get larger the lower you go in strikes. AMAT is currently trading at $50/share, so the $50 strike is ATM. If you wanted to initiate a put ratio spread, you could buy the $50 put at $4.50 ask with an ask IV of 78% and sell two of the $45 puts at a bid price of $2.45 with a bid IV of 82%. (Remember, you can always try to execute your trades somewhere in the middle of the bid/ask. I always do.) This would be a correctly formed put ratio spread.

ILLUSTRATIVE PURPOSES ONLY!

Ideally, you'd want to initiate the position for a credit (just like the backspread) to compensate for the possible large loss due to extra short options. In this example, we'll take in a credit of $.40 per spread. (2 x $2.45 = $4.90 - $4.50 = $.40 Commissions not included). Remember, ratio spreads are for when you think the market is going to sit still or move slowly towards your short strike or totally in the opposite direction. Let's see what this spread looks like graphically.

Since the position is a short-term trade, this is what the P/L scenario looks like at expiration. It's exactly the upside down inverse of what the backspread graph looks like. We see that maximum profits occur right at the short strike price of $45 and then losses start to accrue as we pass down through the short put. If AMAT shoots higher, we keep our initial credit. Again, we want AMAT to sit still, move VERY slowly lower, or go higher. If AMAT finishes at $45, we'll make our max profit of $540.

So what about the unlimited loss with the naked options? I know most retail traders are not qualified by their brokers to sell uncovered options. In this case, all you need to do is buy a much further OTM put option for very little money which will cover you in a disaster scenario. In this AMAT trade, we could buy the June 30 put for say, $.25, which would still leave us with a small overall credit of $.15 in the position. (Commissions not included). Here's the new graph:

The position still loses if AMAT tanks below $40, but that loss will at least be limited as long as we have our $30 put in place. Really, you could pick any strike you to cover the extra short option.

What's the point of having the correct skew? Well, IV lets us know how an option is priced. The higher the IV, the higher the option's premium and vice versa. If you're initiating a spread, you want to buy an option with a lower IV than the option you're selling. If in our AMAT example, the $45 put had an IV of say 78%, it would probably be priced somewhere around $2.25 compared to its original $2.45 price, giving us a $0 net for the spread. So the key is to find options which have a favorable skew to the type of spread you're initiating.

What's the conclusion of the ratio spread? If you find stocks that have large skews within the same expiration month and you feel we'll be rangebound, then the ratio spread is a great trade. You can make money if the stock sits still, moves slowly towards your short strike, or in the opposite direction of your strikes. Just make sure you initiate the spread for a credit and purchase a deep OTM option in case you are unauthorized for naked short options.

Good luck.

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