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What are Back Ratio & Back Ratio Spreads and how to use them in times of uncertainty

Back Ratio Spreads is an option strategy where one would Sell the Call or Put close to the current market price of the underlying and Buy 2 Lots of Higher Call/ Lower Put.

SHUBHAM AGARWAL | 28-Apr-19
Reading Time: 3 minutes

In an attempt of continually reshaping the options trade accounting for the temporarily changing state of affairs especially in the options market, let us see how Back Ratios can help and how should they be deployed.

So, the case here is that upcoming event getting closer is bringing along with itself incremental amount of excitement, which gets translated into higher implied volatility which in turn keep making Options more and more expensive.

The issue is this rising premium regime is an open secret that every one knows so the increments in premium (not led by directions, of course) are so systematically moderate and starts its course so well in advance due to the entire no arbitrage theories and market efficiency phenomenon that it is next to impossible to gain out of it.

On the other hand, the problem that this ever-rising state of volatility brings along is the sheer expensiveness of the Options premiums. This makes trading single options rather unattractive. Just to give an example, think of trading YES Bank just a few months back right after the stock plummeted. Options that typically were trading at 4-5 percent of underlying were now trading anywhere close to 10-12 percent premium.

The only difference here is that with YES Bank it was taking cues of upcoming volatility as an impact of a past event, while here we are taking cues from an upcoming event.

One of the ways to tackle these fat premiums is via Back Ratios. In normal times this may not be a preferred strategy on the list but its apt when the implied volatility is in a rising mode.

Back Ratio Spreads:

This is an option strategy where one would Sell the Call or Put close to the current market price of the underlying and Buy 2 Lots of Higher Call/ Lower Put . This is the trade which comes into play where we have a long month ahead of us before the event and the premiums are getting fatter.

The trade requires us to have movement of sizable proportions in few days. The issue with these movements is a Single Option with Fat premium would impose a large loss, while the Back Ratio would have compounding impact of 2 Options out doing the one Short Option.

Benefit:

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

Caution:

This strategy helps gaining out of direction as well as rise in implied volatility but the drawback is the its heavily negative on Time Value hence only deploy in the first three weeks of the expiry that too with reducing time stop loss of 5, 4 and 3 Sessions as the expiry gets closer.

The absolute returns from Back Ratios are not a handsome as a single Call but the Reward to Risk equation is favourable. Hence, Back Ratios may not be the staple diet or your go to strategy every time but when Time is ample and Implied Volatility is rising Back Ratios could come in very handy.

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SHUBHAM AGARWAL is a CEO & Head of Research at Quantsapp Pvt. Ltd. He has been into many major kinds of market research and has been a programmer himself in Tens of programming languages. Earlier to the current position, Shubham has served for Motilal Oswal as Head of Quantitative, Technical & Derivatives Research and as a Technical Analyst at JM Financial.

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