Ratio call spreads a remedy at the cost of responsibility

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“To enter or not to enter” is always a big question when the indices are making fresh highs.

The question appears to be even more difficult when the indices are struggling (consolidating) around all-time highs.

Options trading comes to the rescue in such situations, with a utility of low-intensity strategies. Options trading shows us how convenient it is to accentuate the benefit of a favorable situation, or many times, how convenient it is to minimise the impact of an unfavourable situation.

One such window of opportunity in options trading is presented by trading option combinations, comprising of ratios, not so popular in normal times due to a greater number of legs and more margin deployed and that extra bit of risk.

But situations that we just mentioned (hovering around the top) makes ratios an apt choice for trade.

While it relieves the pain of a lot of downside risk, there are a few disciplinary trade follow-ups that one needs to adhere to, in order to “have your cake and eat it too”.

Here are two basic kinds of ratio spreads:

1. Ratio spreads:

Let us first discuss the ratio spreads with one buy position in option coupled with multiple sell positions in the option.

Typically, a call ratio spread would involve buying a call option with strike close to current market price and selling two lots of at least two steps higher strike call options.

Similarly, a put ratio spread would involve buying near the current market price put strike and selling two lots of at least two steps lower put options.

An obvious threat here is the additional selling which is done. It brings in a threat of losing out on super performance in our favour due to the additional option sold. But as I said, there is a time and place that would require a solution like this.

Meaning, the last 5-7 sessions of the expiry is when the time value decay is at its highest and that is where the single options bought might actually be outdone in terms of stock price sensitivity by the time value decay.

Here’s where we should deploy ratios, starting from the last Friday of the expiry. Quite possibly, even if it takes a couple of sessions, a two-strike apart ratio would let one have profits when the stock reaches the sold strike.

Advantage:

This trade would give a lot of advantages against the peril of time value decay.

The stop loss would be minuscule and given time would outperform a single call.

Discipline:

The exit strategy should be tightly executed especially the booking of profits or it could turn ugly.

2. Back Ratio Spreads:

This is, in fact, the other way around where one would sell the call or put close to the current market price of the underlying and buy two lots of higher call and lower put.

This is the trade that comes into play where we have a long month ahead of us and the premiums are fat.

The situation requires us to have movement of large proportions in a few days.

The issue with these movements is a single option with a fat premium would impose a large loss, while the back ratio would have a compounding impact of two options out doing the one short option.

The best execution of this trade is when we have some sort of event led excitement expected in the underlying at the beginning of the expiry.

Advantage:

If there is a big move in the favour, we make money while if things do not work out and no matter how lethal is the unfavourable move, the losses are super small or at times there could be a profit from a huge unfavourable move.

Discipline:

With two options long, we are heavily negative on time value decay impact so we need to make sure we execute the trade with at least three weeks to expiry and get rid of the trade within at the most five days of execution.

Thus, ratios can help us get over the peculiar pain points of the options trading with a responsible deployment in the aforementioned cases.

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