Why Break-Even Can Break the Bank with Ratio Spreads
They're low-cost, but they carry risk.
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.
Get options trades from Steve Smith and access to his portfolio - 14 day FREE trial to OptionSmith
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter