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Ratio Spreads – Why and how to use them…

ratio spreads
By
Peter Reznicek
Founder, Editor in Chief

Dear Shadow,

I made some money with you in the last two back spreads on AAPL and PCLN off of your twitter feed. Thanks for those and the blog. Can you please go over your criteria again for when to put on those spreads and when not to? I made money, but I feel like I just followed your trade and don't fully understand why it worked.

Thanks,

Dan D. from East Berlin, CT
 

Dan, your email is in a word, "awesome". Not enough people have this concern. You want to know for yourself, rather than just follow the advice of another. While I truly enjoy giving the advice because I feel that it makes me sharper as a trader, getting everyone to grasp it themselves and be able to execute the setups on their own is an even bigger payoff.

Let's recap what happened on both of those. Both the AAPL and PCLN were ratio spreads. There are also back spreads. A ratio spread is when you buy one option nearer to the money and sell two further out. A back spread is when you are selling one closer and buying two further out. The shorts and longs can be in any ratio (like 2:3) but I always do 1x2's. I only do ratios as well, because I like to receive a credit for putting the trade on and then have a chance to profit again if I get my intended direction. For this discussion, we'll focus on the ratio spread, using the recent PCLN trade as an example.

click to enlarge

The chart above is a daily of PCLN. The arrow is pointing right to Thursday, October 11th when the trade was put on. Weekly options that expire on Fridays begin to trade the Thursday of the preceding week.

The first step in identifying candidates for ratio spreads is to find an issue that has strong support (or resistance for call ratios) on a chart and price appears to be going there but not further. PCLN fit that criteria for me last week as the trend began to roll over to the downside and I believed that the stock would probably visit the support (circled area which is $553.42) within a week's time. Being that the support was between 560 and 550, I chose the 560-550 weekly ratio spread which I was able to sell at a .45 cent credit, selling two 550 puts for every one 560 put bought.

Having done so, I now have a directional bet on a stock that I've been paid to put on. The next step is just to wait. Usually the least favorable pricing will occur at the time of entry. Even if the stock does not move in your intended direction, you'll probably notice that the price of the spread will improve in your favor over time due to the faster decay of the further OTM puts which you are short double that of the longs.

This spread worked out perfectly, as PCLN sold off very close to that support on Friday which was when the options expired. On Friday as price was nearing the upper strike of the spread, its price began to expand well in my favor and I was able to sell off most of them for between a $1 and $1.70 credit. I left a couple on into the close but they went out worthless as PCLN closed above 560.

--Being greedy and putting the ratio on for a larger credit can be detrimental. You receive a larger credit by either having the strikes closer together or putting the whole thing closer to the money. Neither of these work well in my experience. You want the whole thing as far away as possible and also as wide as possible. Too narrow and it won't react as well to the decay. Too close and the underlying could shoot through all the strikes and create a large loss. Remember that the loss is unlimited on ratio spreads if price travels through all the strikes. At least on calls it is but even puts where the stock can only go to zero and not further would certainly wipe you out long before then.

--If it moves too fast on you and the spread begins to expand in value against you, you basically have three options. One is to do nothing and let time do it's thing. This is often the best thing as these spreads are pretty forgiving, especially if you are confident that the short strikes are at a key pivot level. The next choice is to close it for a debit and possibly reestablish it further out for another credit. If the underlying has moved a good bit, you can probably take in another credit and be back where you started as far as cash outlay with a new ratio further out. The third is that you can "butterfly it off". Remember that your spread is long one, short two, so you're just one long short of a regular butterfly. If I had chosen to do this with the PCLN spread, then I would have bought 1 540 put for every 560 that I owned, creating a 540-550-560 put butterfly which would have been riskless except for the price paid for it.

--Once the spread starts trading for a credit to take it off, start thinking about closing partials. The trade above is a perfect example. On Friday, I was sitting in the catbird seat so to speak with PCLN headed towards $550 and expiration measured in hours, not days. However, PCLN closed above $560 so had I not sold off the majority of my spreads during the session, they would have all expired worthless and I would have only made the initial .45 cent credit. In my experience, the odds of the perfect storm happening and closing right at your short strike are minimal.

--If the underlying trades in the opposite direction of the spread, you can sell off the long vertical part of the ratio for another credit and leave yourself with a single short option. Riskier though, and not recommended for novices. Often better to let it all go out worthless and sleep well knowing you have the initial credit in your pocket.

Experiment with different stocks and indices to put these spreads on. They work well in the SPX and in most of the meatier, expensive stocks. You'll find cheaper stocks are more difficult to enact them on. Put a few just into your analyze tab and then watch their prices for awhile to see how they move when the underlying moves.

Good luck, and may all your ratios expire right at your short strikes.

Click here to continue reading with Ratio Spreads part 2

Written by Peter Reznicek

Peter Reznicek is the founder of ShadowTrader.net and writer of Peter's Premarket Perspective, a morning market profile blog to help people plan their trading day and organize their thoughts before the market opens. He can be reached at asktheshadow@shadowtrader.net.

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