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How to manage high and low volatility using ratio spreads, an advanced options strategy.

  • Fidelity Active Trader News
  • – 10/24/2013
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A ratio spread is an options strategy for traders that are moderately bullish or bearish on a stock, but think the price move will be relatively small. However, if volatility is expected to increase, along with a sharply higher move by the stock, a variation of the ratio spread—known as a call backspread—is designed to take advantage of this forecast.

What is a ratio spread?

Ratio spreads consist of buying and selling a different number of options contracts (either puts or calls, but not both) on the same underlying asset with the same expiration date at a different strike price. For instance, a trader who is simultaneously short two call contracts and long one call contract on the same underlying security would have a 2:1 ratio spread.

Ratio spreads can be used in several different circumstances. In many cases, they are simply a strategy that results from adjustments being made to existing positions. Common examples include adjusting single-leg call or put positions or spread strategies because expectations have changed since initiation.

There are reasons why someone might execute a ratio spread as a standalone strategy as well. A trader could profit from the use of a ratio spread when volatility is expected to decline over the life of the options contracts being used. If a trader is moderately bullish or bearish on an underlying security, but the price move is expected to be limited, a ratio spread might be ideal. If the underlying security does move in the expected direction, the profit potential would be higher than it would with a simple spread option strategy. However, if the price movement is greater than anticipated, the losses could be large.

A hypothetical ratio spread

A note about ratio spreads

Please remember that ratio spreads involve uncovered options. Writing uncovered options is suitable only for the investor who understands the risks, has the financial capacity and willingness to incur potentially substantial losses, and has sufficient liquid assets to meet applicable margin requirements. Any time you write an uncovered option, you expose yourself to significant financial losses. If the value of the underlying instrument(s) moves against you, your losses could be many times greater than the cost of the option itself. If an underlying instrument is affected by rapid price volatility or high trading volume, you may be unable to close out your position and you may be forced to endure significantly greater losses than otherwise.

To construct a ratio spread, a trader would buy at least one option contract, while simultaneously selling a greater number of options contracts that are further out of the money on the same underlying.

For example, assume at the beginning of October that XYZ Company is trading at $50 per share. A call ratio spread could be constructed by purchasing one November $50 call for $4 per contract at a cost of $400 (100 shares controlled by the contract times $4 premium) and selling two November $55 calls for $2.50 per contract for a credit of $500 (200 total shares controlled by the two contracts times $2.50 premium).1 This ratio spread would result in an initial net credit of $100 ($500 in credit less the $400 cost). It’s important to note that ratio spreads can be established at a credit or a debit, depending on the contracts being used.

In this example, the maximum gain occurs at the strike price of the short option contracts. The maximum profit potential is $600. If the stock closed at $55 per share on the expiration date of the options in use, the intrinsic value of the long call contract would be $500 ($55 market value of the underlying security less the $50 strike price of the long call option). At this price, all of the short contracts expire worthless, so the $100 credit received for establishing the position would be profit as well.

Now, let’s assume the underlying price appreciates beyond $55. In this scenario, the trader is exposed to unlimited potential losses. The higher the ratio, or more short contracts in relation to long contracts being used, the more magnified the potential losses may become.

Backspreads

A ratio spread would be appropriate for an options trader who expects volatility to decrease. But what if volatility is expected to increase? Consider backspreads.

A backspread can be thought of as taking a long position, either bullish with purchased calls or bearish with purchased puts, and financing that position via the sale of a credit spread on the same underlying security.

When used in place of a standard spread position, the advantage of the backspread is that it provides unlimited potential gains when using call contracts or substantial potential gains when using puts. Compared to a simple long call or long put strategy, a large enough move in the price of the underlying could result in a greater return on investment, due to the lower initial cost. Also, if the trader is incorrect in his or her analysis, and the underlying price moves in the opposite direction to the one he or she anticipated, potential losses are minimized.

Backspreads consist of at least one short option contract (calls or puts, but not both), combined with multiple, further out-of-the-money, long option contracts. Backspreads can consist of any number of long contracts compared to short contracts. They can also be established at either a credit or a debit, depending on the contracts being traded. Unlike ratio spreads, backspreads require an increase in volatility and/or a significant price movement from the underlying security during the life of the options contracts being used in order to be profitable.

A hypothetical call backspread

To construct a call backspread, a trader would sell call options at a lower strike price and buy a greater number of calls at a higher strike price.

Once again, assume at the beginning of October XYZ Company is trading at $50 per share. A call backspread could be constructed by selling one November $50 call for $4 per contract for a total credit of $400 (100 shares controlled by the contract times $4 premium) and buying two November $55 calls for $2.50 per contract at a cost of $500 (200 total shares controlled by the two contracts times $2.50 premium).

In order for the trade to break even, the maximum loss amount needs to be recovered by the remaining long contract before any gains can be realized. In this example, the stock price must appreciate to at least $61 by the expiration date. It is at this price that the remaining long $55 call has enough intrinsic value to make up for the realized losses on the rest of the position. Potential gains are unlimited as the underlying security appreciates beyond this price. Any gains would be magnified by a higher quantity of long contracts, but additional upfront costs would be incurred. Should the stock move lower, or remain flat, all of the contracts would expire worthless, and losses are limited to the initial cost of $100.

An important consideration with the call backspread is the risk of early option assignment. While this should always be a consideration when selling options contracts, in many cases this particular strategy often involves being short contracts that are in the money. This may result in elevated risk, and warrants special attention when evaluating the strategy.

The bottom line

When constructing a ratio spread, carefully consider your risk and return objectives. Understand the implications of increasing the ratio of purchased or sold calls and puts, and how the Greeks might be impacted. Ratio spreads offer a way to trade different levels of volatility.

Learn more

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Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk. Prior to trading options, you must receive from Fidelity Investments a copy of "Characteristics and Risks of Standardized Options” and call 1-800-343-3548 to be approved for options trading. Supporting documentation for any claims, if appropriate, will be furnished upon request.

There are additional costs associated with option strategies that call for multiple purchases and sales of options, such as spreads, straddles, and collars, as compared to a single option trade.

1. For simplification purposes, we will not consider the impact of taxes or dividends on each hypothetical trade in this article.
Greeks are mathematical calculations used to determine the effect of various factors on options.
Views and opinions expressed may not necessarily reflect those of Fidelity Investments. These comments should not be viewed as a recommendation for or against any particular security or trading strategy. Views and opinions are subject to change at any time based on market and other conditions.
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