Limit Your Risk and Boost Your Profit Potential with the Ratio Credit Spread
Do you want a risk averse credit spread with the potential for excess profit? The ratio spread could be your ticket
In today’s volatile and unpredictable markets, you may feel more comfortable adding an extra layer of protection to your option selling trades “just in case.” An effective tool for accomplishing this goal is a strategy known as the Ratio Credit Spread.
Also known simply as a ratio spread, this is a strategy that offers a layer of protection while also the ability to profit more if the market moves against one’s 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 three options for every option that you purchased, the ratio would be 3:1.
In a credit spread, if all of the options involved expire worthless, the trader’s profit will be the net credit he received from the option sale, after purchasing the at the money option(s) and paying transaction costs. Credit spreads are discussed in detail in the Video DVD included in our Investor Information Pack and are a core strategy in the portfolios for our private client group.
Benefits of Using a Ratio Credit Spread
If you read The Complete Guide to Option Selling 3rd Edition, you’ll see I described the ratio credit spread as the “Mazzerati” of option spreads. There was a reason for that. The reason, is that it offers a combination of benefits to an investor not found in any other spread. In addition, it is still practical enough for most individual investors to use.
What are the benefits of purchasing this additional option as opposed to simply selling naked?
The benefits are threefold:
- 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.
- 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.
- 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.
How to Use a Ratio Credit Spread
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.
The example below may illustrate how a credit spread can work.
EXAMPLE: RATIO CREDIT SPREAD IN CRUDE OIL
A trader who is neutral to bullish the crude oil market wants to sell puts beneath the market. He elects to sell the December 45 Crude Oil put because although he is not sure where prices will be in November (option expiration), he feels fairly confident that they will still be above $45 per barrel. The trader sells 3 of these December 45.00 Crude Oil puts for $800 each* for a total premium collected of $2400. He then sees the December 50.00 puts selling for $1100 each. He takes a portion of the premium he collected from selling the 45.00 puts and buys one December 50.00 put.
His credit is as follows: $2400 – $1100 = $1300**.
DECEMBER CRUDE OIL
Ratio Credit Put Spread: Sell 3 December 45 puts, Buy 1 December 50 put
If crude oil continues to move higher or remains range bound, all of the options expire worthless and the credit will be the trader’s profit ($1300). If the crude market moves lower, but remains above $45 per barrel, the profits could be higher.
If the market moves below $45 per barrel and the trader remains in the position, he could experience a loss.* Premiums reflected are for example purposes only and may not reflect current premiums
** Minus any transaction costs[/p]
Potential for Extra profit in the Ratio Spread
Extra Profit – Method 1
The ratio spread can be a versatile strategy that can be worked to your advantage in a number of different circumstances.
For instance, suppose on option expiration day, December crude is trading at $48 per barrel. The 45 puts would expire worthless ($2400 profit). The 50 put would expire 2 dollars in the money, meaning it is now worth $2,000. If the cost of purchasing this option ($1100) is subtracted, it nets a profit of $900. Therefore, the net profit on the trade would be
$2,400 (profit from short puts) + $900 (profit from long put) = $3,300*
Extra Profit – Method 2
If the options are nowhere close to going in the money, it is also often possible to sell the “protective put” as the options near expiration. You can often recoup several hundred dollars from the sale of your long option – even if it’s not in the money. You then allow the remaining short options to expire worthless.
Risk and Risk Management of the Ratio Credit 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 beyond 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 many investors are willing to pay for the increased protection the credit spread can offer.
Ratio credit spreads may not be perfect for every market. Selling naked may be a preferable strategy in some situations. However, ratio credit spreads can work very well under the right market conditions, offering a “risk resistant” trade while allowing for steady time decay. For this reason, they can be a valuable tool when you are structuring a properly balanced portfolio.
To learn more about the ratio credit spread, You’ll find an entire chapter devoted to this single spread in The Complete Guide to Option Selling 3rd Edition. You can get your copy now at a 40% discount of the cover price by going to www.OptionSellers.com/Book.
James Cordier is the founder of OptionSellers.com, an investment firm specializing in writing commodities options for high net-worth investors. James’ market comments are published by several international financial publications and news services including The Wall Street Journal, Reuters World News, Forbes, Bloomberg Television, Fox News and CNBC. Mr. Cordier’s book, The Complete Guide to Option Selling 3rd Edition (McGraw-Hill 2014) is available at bookstores and online retailers now. Michael Gross is Director of Research at OptionSellers.com. For more information on OptionSellers.com’s privately managed option selling portfolios, go to www.OptionSellers.com/Discovery
Price Chart Courtesy of CQG, Inc.
***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.