What is a Option Ratio Spread?

Option Ratio Spread

A Ratio Spread involves buying (long) in-the-money options and selling (short) a greater number of out-of-the-money options of the same type and same expiration month. The option that is sold should have higher implied volatility than the option bought. This is called volatility skew. The trade should be made with a credit. That is, the amount of money collected on the short options should be greater than the cost of the long options. These conditions are easiest to meet when volatility is high and stock price is between the strike prices.

Risk is unlimited to the upside on call ratio spreads and to the downside on put ratio spreads. Since risk is unlimited, we require a very large volatility skew and all ratio spreads must be entered with a credit. This results in very few trades.

Let's look at a call ratio spread trade. Since January 2003, our system has only identified one ratio spread. On October 18, 2005 we entered a call ratio spread on America Movil, S.A. de C.V. (AMX) by buying 10 Jan $21.625 strike call options and selling 13 Jan $26.625 strike call options. These strike prices are due to the 3:1 stock split on July 21, 2005. AMX closed at $23.78 the day before. The $26.625 strike call that was sold had a premium of $2.75. The $21.625 strike call that we bought was $3.40. Implied volatility on the $26.625 strike call was 76.22% and the $21.625 strike call was 41.80%. Note the greater than 30% skew in implied volatility. The profit graph for this position is shown below.

Note that there is unlimited risk to the up side due the greater number of $26.625 strike calls sold. The credit on this trade is $175.00 and maximum profit is $5,173.00. Upside breakeven is at a stock price of $43.88 and the trade is profitable at all stock prices less than $43.88 at expiration. Since we are net short options, a margin is required on this trade.

On these trades, we calculate the probability of capturing some percentage of maximum profit. If we want 25% of maximum profit on this trade, it would be $1,293.25 ($5173 x 0.25 = $1293.25).

We calculate the probability of capturing 25, 50, 75 and 99% of the maximum profit on ratio spread trades tested each night. If 25% level probability is 95% or greater we recommend the trade. We target is 2.5% or greater of the maximum profit. The trade is always closed if stock price reaches the short option strike price. After 10 days we bail out of trade at break even or any profit.

In the case of this AMX trade the probability of capturing 25% of maximum profit was 100%, 50% was 71.63%, 75% was 56.57% and 99% was 54.23%. Since the 25% level probability was greater than 95%, we took the trade and targeted capturing 2.5% of the maximum potential profit. On this trade, that profit would be $129.33.

The trade was closed on October 24, 2005 with profit of $170.00 or 3.3% of maximum profit in 6 days. Some traders would hold this trade until stock price reached the up-side breakeven price in the hope the trade expires below that level for a larger profit.