How to Sell the Ratio Credit Spread
Michael Gross explains what he considers to the “the best” option selling strategy – The Ratio Credit Spread. Learn how to sell commodities options for premium and also give yourself substantial upside.
Hi, this is Michael Gross, co-author of The Complete Guide to Option Selling, here with your bi-monthly option selling lesson. This is part of our option selling institute segment of OptionSellers.com. The subject of this week’s lesson is a good one; it’s the Ratio Credit Spread. The ratio credit spread, for those of you that have read our book, The Complete Guide to Option Selling, we refer to it as the Maserati of option selling credit spreads. There’s a good reason for that. The ratio credit spread is one of the most versatile ways you can collect premium and manage your downside risk. That’s what we’re going to talk about here today. For those of you that haven’t read the book yet, it is called The Complete Guide to Option Selling. This is the third edition, just published in 2014. You can get it on our website at www.OptionSellers.com/Book if you’d like to read it.
So, what is a ratio credit spread? For those of you unfamiliar with what a credit spread is, a credit spread is typically a combination of buying and selling options in which case you receive a net credit for doing so. What that means is the amount of options you sell will outnumber what you buy, so if everything expires worthless you’ll still be keeping a premium. Obviously, that’s what you want as an option seller. How does a ratio credit spread work? Well, it’s best demonstrated through example so that’s what we’re going to do. If you read the print article that talked about the ratio credit spread that is associated with this video, you’ll know I used a put ratio credit spread. That would be for if you were bullish the market and you wanted to sell put options underneath it. In this example, I’m going to show you a ratio call credit spread. This is what you would use if you were neutral to bearish a market. For the example, we’re going to use the same market, crude oil. Let’s just assume that is the crude oil chart and we’re trading in a range between $50-$60, that’s kind of where it has been recently. Please bear in mind that this is just for example purposes. I’m going to use option values here that probably don’t correspond with what the actual option values are, but this is for example purposes.
Let’s say, today, crude oil was at $60 a barrel and you are neutral to bearish the crude oil market. Now, to write a ratio credit spread, obviously you’re going to go above the market, so let’s assume you go above the market and you don’t think the market’s going to make it to $75 a barrel. Up here is $75 a barrel. You decide you want to write some calls up there and the $75 call option for December… $75 call options, you notice those are going for $800 a piece. What you’re going to do is you’re going to sell 3 of those options. You would collect a total premium of $2,400 for doing that. Now, to make this a ratio credit spread, you’re going to look down here and you notice the $70 crude oil call option is going for $1,100. You’re going to take some of this premium you collected here of the $2,400 and you’re going to take $1,100 of that and you’re going to buy one of the 70 call options. So, you’re selling 3 of the 75’s, you take a part of that premium, you’re buying one of the 70’s. That’s a 3-1 ratio. That’s why it’s called a ratio credit spread. You’re selling 3 and you’re buying 1.
Now, why on earth would you do this? You say, “Why wouldn’t you just sell the 75’s and be done with it and take the full $2,400?” Well, there’s a couple of good reasons why. A ratio credit spread has a number of benefits and, for our private client group, we’re typically always keeping our eyes peeled for ratio credit spreads because when you can put them on at a good spread, we feel there’s no better credit spread out there. It’s so versatile that you can do a lot of things with it even while you’re in it. For the purposes of this, we’re going to talk about the top 3 benefits of writing a credit spread this way. For now, I want you to see how you do it. You sell 3, you buy 1, okay?
I’m going to leave that up there but we’re going to talk about benefits right now. What’s the number one benefit of a ratio credit spread? Protection. This is why we sell ratio credit spreads because if you’re wrong that market and crude prices start heading up, yes your 75 call options at the 75 strike, those three call options are going to start increasing in value, but you purchased one of the 70 calls. It’s closer to the money, it’s going to be accumulating value, as well, and it’s not going to be offsetting the loss on the three options together, but it’s going to be offsetting a good portion of it because it’s closer to the money. So, while you’re losing money on your short calls you’re making money on the long call. It’s a slower type of trade. In volatile markets, that can be a big benefit. It helps smooth out the equity curve, it helps you stay in the trade longer, which we’re going to talk about in a little bit, it’s more of a smoother type of position to begin as opposed to something that’s moving net value day after day. It’s more of a balanced type position.
What’s the second big benefit? This is a big one because a lot of credit spreads offer you this (protection), not very many offer you number two: Potential for increased profit. Now, for this example, what we just talked about, if crude oil stays below $70 a barrel through expiration of this trade, all of these options are going to expire worthless. So, what you would keep is the difference between these two because you lost your premium on your $1,100 protective call but you’re still keeping the premium for your 3 $75 short calls. So, it’d be the difference between these two… $2,400 minus $1,100 would be $1,300 net credit, as they say. If everything expired you would keep that credit of $1,300 per spread. So, if the thing expires below 70, you’re keeping $1,300 per credit spread minus any transaction cost. What if it doesn’t expire below 70? What if the price of crude oil continues to rise and goes above 70? Well, if you were to short the calls you’d probably just have to get out and take your loss. In a ratio credit spread that’s not necessarily the case. In fact, you could end off even better off than you would be if the thing just expired. Here’s why: Here’s our crude chart. Here’s crude sold at 3 75’s, you bought the 70. As crude starts going up, it goes above 70, it doesn’t make it to 75. It’s sitting there about let’s say $72 a barrel. It expires, expires with crude oil going off the board, the options go off the board, December crude is at $72 per barrel. What does that mean? Well, it means all 3 of your $75 calls expired worthless.
So, you made your $2,400 on those because you kept that premium. Your 70 call has expired $2 in the money or, as crude oil goes, that means it’s worth $2,000 per option, so you close that out, it’s worth $2,000. Not only are you making $2,400 on your short calls, you get $2,000 back on your long call. Now, you paid $1,100 for this protection so you’d subtract that, which means you made a profit of $900 on the long call, which gets added to this. Your net take, if the thing goes off the board at 72, is $3,300 per spread. There is a scenario with ratio credit spreads where even if it’s moving against you, as long as it doesn’t move too much, at the end of the day you could end up with a lot more than just your net credit of $1,300. It doesn’t happen very often, but it happens enough to make these worth while doing because it’s nice when it does.
Now, we have one more benefit to talk about of the ratio credit spread, which we covered earlier. The third big benefit of ration credit spread is staying power. What we mean by that is it allows you to stay in your trade, stay in the market through many different types of market movements, especially adverse moves, and remain in your position because of this off-setting type of feature to it. Now, you can’t stay in it forever. If the thing starts going up and it goes through 70 and still heading to go above 75, you’re going to have to close it out at some point there and then you can take a loss. Typically, we don’t recommend keeping a hold onto a ratio credit spread beyond your short call strike. So, if the thing is up above 70 and you wanted to keep an eye on it, if it goes above 75, depending on how much time is left on it, that’s probably a place to get out of the thing. Nothing is guaranteed, there is no perfect strategy, you can still take losses on a ratio credit spread, but it’s really got to move against you by a large degree and it has got to move pretty quickly. Although it does slow the market down, it gives you a lot more staying power. The market can move against you by a fairly sharp degree and you can typically remain in a ratio credit spread without too big of a standing loss on the thing until it really starts taking off. Staying power is the third big reason you would do a ratio credit spread.
Before we end this week’s lesson, the ratio credit spread, as I said, there’s no perfect strategy and there are drawbacks to ratio credit spreading. Probably the biggest drawback is you can’t do them on every market. Typically, a ratio credit spread has to be written in a market that’s, one, there’s big premium to begin with and, two, there’s got to be some volatility in it because those spreads have to be wide enough to make it worth while for you to get your spread on, get a good premium in return, and still the strikes have to be close enough so you can get that layer of risk protection. The closer the strikes, the more risk protection you’re going to have. If they’re too far apart then sometimes that risk versus reward ratio just isn’t there. Typically, a ratio credit spread will work best in your bigger markets like your crude oil market, natural gas market, soybeans occasionally, and you need simply a time when there’s some volatility there. If you go in smaller markets, and I don’t want to say never because you can when they get volatile enough you can write credit spreads in almost anything, but your higher larger contracts are probably going to be where you’ll find the most. Gold and silver can also be good markets for ratio credit spreading when you get some volatility into the market.
One more drawback to ratio credit spreading… to get your full profit on a ratio credit spread, you typically have to stay in the trade right up either almost until or until expiration. Unlike a naked put or call where you can buy out of it early and take your profits, if you want to get most of the profit out of a ratio credit spread you typically are going to have to hold it almost all the way until expiration. If you can live with those two drawbacks, the ratio credit spread can be a great way to collect premium in markets and really tend to slow things down for you, give you that extra layer of protection, and also give you a chance, occasionally, to take in a lot more profit than you had initially targeted. That’s why I recommend ratio credit spreads.
As I mentioned, if you’d like to learn more about ratio credit spreading we devote a whole chapter to it in The Complete Guide to Option Selling: Third Edition. I also mentioned they are a favorite strategy of our managed portfolios that we implement on behalf of our private client group. If you’d like to learn more about the private client group and how you can get involved, I do recommend getting our Option Seller Discovery Kit. It’ll tell you all about our program and how you can get involved. It also comes with a free 30 minute DVD of James Cordier’s seminar to high net-worth investors. Thank for watching this week’s lesson. We’ll see you in two weeks.