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November 14 , 2006

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A Look at Option Spreads – Part II

Name: Chad Butler

Company: RJOFutures

Learn More About Today's Author
Years Trading: 16

Favorite Movie: Glengarry Glen Ross

A Look at Option Spreads – Part II

The use and benefits of option spreads are often overlooked by a great many traders.  Most likely this is due to a lack of understanding of options in general or a belief that the strategy is, in some way, difficult to understand.  This is unfortunate because option spreads can provide traders with a way of limiting risk while achieving an acceptable return probability.  Properly used, option spreads may offer the trader an opportunity to trade markets they might not otherwise trade. 

In Part I, we covered the use of debit and credit spreads: 

  • Bull Call Spread (debit)
  • Bear Call Spread (credit)
  • Bull Put Spread (credit)
  • Bear Put Spread (debit)

These strategies involve the simultaneous purchase and sale of different strike prices of the same type (call or put) option.  In the case of the debit spreads, the risk is limited to the amount paid for the position (difference between the option purchased and the option sold) while the maximum possible gain is the difference between the strikes less the cost.  For the credit spreads, the trader receives a net credit at entry.  This is the maximum possible gain while the risk is the difference between the strikes less the credit. Each of these strategies has its place and may or may not be appropriate for all investors depending on trade objectives, risk tolerance, and account size.  For a full discussion of these strategies, with trade examples, click here to receive Part I of this series as well as our Option Strategy Guide.

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Our next position builds on the previously discussed spreads – the ratio spread.  In the previous examples, we dealt with one option at each strike.  In the ratio spread, we will trade multiple options at a given strike relative to the number traded at another strike.  In other words, the number of options at a given strike is a “ratio” of the options at another strike.

The first example we will discuss is a ratio call spread.  Its construction is similar to the bull (or debit) call spread, but we sell more than one call.  In this example, we will be selling two out-of-the-money calls and buying one closer-to-the-money call.  However, there are times that, in order to give a reasonable risk/reward ratio; a trader will need to increase the ratio by selling three (or more) out-of-the-money calls.

In the ratio spread, we give up the limited risk that was in the simple debit spread.  As an exchange for taking more risk, the upside potential is higher.  Think of it this way: by selling more calls we believe will expire worthless, we are bringing in cash to help us buy a call that we believe will not expire worthless.  That sounds like a fair deal, doesn’t it?

In this example, we will purchase the February Gold 640 call.  For each 640 call purchased, we will sell two February 700 calls.  As of this writing, this spread can be obtained for a net cost of $690 (buying the 640 for 2330, selling the 700s for 820 each) and the options have 73 days to expiration.  The maximum possible gain on this trade at expiration is $5306.  The maximum risk is unlimited.  Take a look at the Profit/Loss graph of this option position at expiration.

Here is a key point on the risk of a ratio spread that many new traders miss – gold at 700 is not where we start losing money on this position.  Remember, at that point our 640 call will be $60 in the money (or $6000 per contract).  That gives us room to offset what we would be losing in the 700 calls.  So we don’t really start going negative until about $760 at expiration.  Could gold move $120 between now and February expiration?  Yes, that is always a possibility.  But the average monthly range of the futures shows that as being less likely.

Traders that take a position like this will need to have some money in the account to margin the short calls.  Additionally, it is highly recommended to allow extra cash for a hedge using the futures, should the need arise.  If gold made an extreme extension this month that would take us shooting through 750 and then some, we would want to hedge the extra short call using the futures.  By buying a futures position against the extra short call, we essentially “cover” the call.  Note, however, that we only do this against an extreme move against us in the market.

A ratio spread could also be used in a situation where we are bullish on the market, but feel that if it breaks, it will break hard.  Here is an example that will take advantage of selling premium to leave the trader with a credit but will also profit in the case of an extreme downside break.  The position will be constructed as a put ratio spread (or ratio credit spread).  This is done by selling a closer-to-the-money option (in this case a put) and using some of the proceeds to buy more than one farther out-of-the-money option of the same type.  Our example will be as follows: we will sell one at-the-money put (640 strike) for 26.90 (or $2690 per contract).  Using some of that capital, we will buy two 600 puts for $960 each.  That leaves us with a net credit of $770. 

Unlike the straight credit spread (which would be a bull put spread or bear call spread), that $770 is not the cap on what we can make in this position.  If gold were to completely fall apart and break hard to below 572 we would begin to exceed that, due to the extra long put.  However, similar to the credit spread, we have capped our risk on the trade.  At expiration, our maximum loss would be incurred right at 600 where our 600 puts would expire worthless and the 640 put would be $40 (or $4000 per contract) in the money.  Take away the $770 we brought in for the position and our maximum possible loss is $3230.

You can probably see that this can be a powerful strategy in the right market conditions - and gold may fulfill that requirement - but it does come with larger risk.  Like the debit ratio spread, we could hedge downside risk using the futures if necessary.

The final example in this installment is fairly aggressive.  We will buy a February 620 put for $1680 while selling three February 600 puts for $1200 each.  This gives us a net credit of $1920.  If we are correct about gold going higher from here, we would walk away from this trade with the net credit.  If gold were to drift lower, at expiration we have the opportunity to make as much as $3810 (if gold is at $600 at expiration).  At expiration, this trade is positive all the way down to 583, where it would turn negative.  That gives us a considerable amount of room to work with.

Recall, however, that I mentioned this is an aggressive trade.  It does carry unlimited risk for limited gain.  Also, in the example given, there is a fair amount of time left to expiration in order to receive such a large credit.  When you are net short option premium, more time equates to more risk.  With this P/L graph, I have included the option value at 12/25/2006 (a little more than half way to expiration).

As you can see, if we hold this to expiration, the market is more forgiving in terms of where we can see a profitable trade.  However, if the market were to trend down for the next month or so, we would probably need to either offset one or more of the short puts or hedge the position using futures.  It is a good idea to have your damage control plan in place before you get into a trade.  This type of trade works best when used in conjunction with a larger approach to the market.

While all of the examples discussed in this article perform best in a bullish market, opposite positions could be constructed for bearish market conditions.  I hope this article has given you some insight into how you can use ratio spreads in your trading plan.  These strategies, like any strategy, should fit into a well thought out plan that includes not just an overall market outlook, but specific risk control and money management.

About Today's Author

Chad Butler is a Senior Market Strategist with RJOFutures, a division of R.J. O'Brien. His 16 years of market experience includes option spread trading, diversified trend following, and development of a number of index arbitrage programs. Chad’s published work appears in McGraw-Hill's Complete Guide to Single Stock Futures, Futures Magazine, and other trade publications.  He currently writes for various commodities newsletters, including RJOFutures MarketNews and has been a featured seminar speaker teaching his various trading techniques to audiences large and small.

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