Trading options with ratio combinations, a convenience yet a responsibility

Options trading time again shows us how convenient it is to accentuate the benefit of a favorable situation or many times how convenient it is to minimize the impact of an unfavorable situation.

One such window of opportunity in Options trading is presented by trading Option Combinations comprising of Ratios.

Ratios are not so widely used and discussed due to its incremental legs, in other words requirement of execution of 3 trades to take position in one underlying. Still they have a specific time and place where nothing else would work as effectively as Ratios.

We will understand what are these ratios and the correct time and place to get the most Convenience out of them Responsibly one by one.

#1 Ratio Spreads: Let us first discuss the Ratio Spreads with one Buy position coupled with multiple Sell positions in Option. Typically, a Call Ratio Spread would involve Buying a Call Option with strike close to the current market price and Selling 2 Lots of at least 2 steps higher Strike Call Options. Similarly, a Put Ratio spread would involve buying near CMP Put strike and selling 2 lots of at least 2 steps lower Put options.

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

Meaning, that the last 5-7 sessions of the expiry are 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 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.

Convenience: This trade would give a lot of advantage against the peril of Time Value Decay. The stop loss would be minuscule and given time would outperform single Call.

Responsibility: The exit strategy should be tightly executed especially the Booking of Profits or it could turn ugly.

#2 Back Ratio Spreads: This is actually the other way around 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 that comes into play when 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 Fat premium would impose a large loss, while the Back Ratio would have a compounding impact of 2 Options 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 in the Beginning of the expiry

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

Responsibility: With two Options long we are heavily negative on time value decay impact so need to make sure we execute the trade with at least 3 weeks to expiry and get rid of the trade within at the most 5 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 use cases.