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Why Break-Even Can Break the Bank with Ratio Spreads


They're low-cost, but they carry risk.

In last week's article, Back Spreads Insure Against Investing Catastrophes, I discussed using back spreads as a means to establish a low-cost position that would benefit from a sharp directional move and increase in implied volatility. This week I'd like to look at its kissing cousin, the ratio spread.

In a back spread, one buys a multiple number of contracts relative to the number sold short. In a ratio spread, it's the opposite: It's structured by selling more contracts than those purchased. The options owned will be closer to the money while those short are further out of the money.

For example: A 1x3 ratio call spread in Apple (AAPL) might be constructed by buying one September $175 call for around $3.10 and selling three September $185 call for $1 a contract. That means the position is established for just $0.10, or $10 per 1x3. So a position of 10x30 contracts would cost $100. That's the maximum loss if shares of Apple are below $175 on the September expiration. The maximum profit is $9.90 if shares are at $185 at expiration. The break-even point -- or the level at which you would start losing money -- is $195 a share.

Beyond Break-Even Can Break the Bank

In ratio spreads, the break-even point is important to be aware of because you're net short options contracts, so losses are theoretically unlimited and can mount quickly. Therefore, the application of a ratio spread only makes sense if you're comfortable with risk and confident in your belief that the stock in question won't post a huge move beyond the break-even point. In the case of Apple, that means the shares shouldn't rally more than 9% over the next four weeks.

Getting Long at the Top

I'm staying away from trading Apple but I'm using a ratio spread in the Spyder Trust (SPY). I'm really not comfortable getting straight out long at these new highs, but by using a ratio spread, I can gain some broad market upside exposure for little or no cost. More importantly, while I think stocks can move higher, I think near-term gains will be somewhat limited. Simply put, after the recent rally, I just don't think the market is ready for another melt-up in September.

The obvious immediate target for the S&P 500 Index would be the 1050 level. This is not only a 50% retracement from the March low, but represents a gap-down left last September and therefore should present resistance.

The position I'm using is to buy 10 September $103 calls at $2.75 a contract and sell 25 September $106 calls (SWGIB) at $1.30 a contract. This 1x2.5 ratio spread was done for a $0.10 net credit. Meaning, if shares of SPY are below $103 at expiration, the position won't incur a loss.

The maximum profit of $3 is realized if shares are at $106 at expiration. The all-important break-even point is $108, or a another 4.9% rally in the S&P 500 or the Spyder Trust from current levels.

By using a ratio spread, the strategy also takes advantage of the fact that implied volatility levels are running at a large premium to the real or historical volatility of the index products. If stocks move higher, then IV should decline -- which would benefit the ratio spread.

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No positions in stocks mentioned.

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