Contents
Today, we will talk about the spread ratio option.
Specifically, we will look at the callback ratio distributed on the SPX.
This spread can be constructed with call options or put options.
It will be easier to explain if we go straight to an example.
On January 10, 2024, the SPX was trading at 4775 and an options trader sold an out-of-the-money call.
And I bought two more out-of-the-money call options.
Date: January 10, 2024
Price: SPX @ 4775
Sell a January 26 SPX 4830 call at $20.23
Buy two January 26 SPX 4875 calls at $8.79
Net credit: $265
Looking at the closing chart (blue line below), we see that this trade has a maximum loss of $4235 where the line sinks into a “valley of death”.
However, this can only happen at expiration (in our example, 16 days) and only if the SPX lands at 4875
If it happened that the SPX is at 4875 at expiration, the call options would be worthless because the SPX had not exceeded the call strike price of 4875. Thus, the trader would not profit from the long calls.
The short call with a strike price of 4830 would be 45 points in the money. That’s a $4500 loss. Since the $265 credit was taken when the trade was initiated, the net loss would be $4235 if the SPX is $4875 at expiration. This would be the maximum loss in the trade if held to expiration and would be very unlucky.
A rosier picture emerges when looking at the current yield curve (or T+0 line). This curve shows profits and losses today, as opposed to expiration.
We see that it is inclined to the left and to the right. This means that we win if the SPX price goes down and also if it goes up.
We don’t have to choose the right direction to win. It is one non-directional strategy.
That’s why the guideline delta it is too small.
Delta: 3.6
Theta: -52
Vega: 169
However, the negative theta is important. Negative theta means the trade loses money over time.
Most traders of this spread will only stay in this trade for a very short time. In our example, they might stay in for a day or two and come out. This keeps any losses to a minimum. The longer you stay in the trade, the more you can lose. In fact, if you stay in the trade until expiration (don’t do this), you can lose up to the maximum loss.
Trade is vega positive because we buy more options than we sell. So it has the characteristics of a long option – long vega and negative theta.
The ratio spread in this format is used when the trader believes a large price move will occur, but does not know its direction.
For example, known future news events that can potentially move markets, such as elections, earnings/financial reports, FOMC meetings, federal policy announcements, etc.
These are what are referred to as “known unknown” facts. We know the event will happen, but we don’t know what the result or reaction will be. These events are tradable and compensable.
Regarding “unknown unknown” events (such as Black Swan events), these events are not tradable but compensable.
In our example, the spread ratio started a day before the release of the CPI (Consumer Price Index) economic numbers.
The trader could attempt to trade the event by initiating a strategy that would benefit in the event of a large move in an unknown direction.
Another trader might have a bunch of income neutral strategies such as iron condors, who don’t like large price movements. So this trader can hedge the portfolio by adding a return ratio spread that likes big price moves. If iron condors lose money due to a big price move, the ratio back can be part of that money.
Let’s see how our example trade went.
Did the SPX make a big move after the CPI report?
Not really. It was almost a non-event.
Did the spread-ratio make money? Not really; the price did not move enough.
Did the spread ratio lose money? Not really – if the trader closes the trade the next day.
The next day, the trader decided to close the spread with:
Date: January 11, 2024
Price: SPX @ 4768
Buy to close a January 26 SPX 4830 call at $14.64
Sell to cover two January 26 SPX 4875 calls at $6.07
Charge: -$250
The chart looks pretty much the same as when it started.
Credit $265 to open and charge $250 to close means $15 profit. With fees and commissions, this would be less. Let’s call it dead.
How does the back ratio differ from the ratio spread?
The spread ratio is when you sell one option and buy two options further away. The spread ratio (also known as the spread ratio) is when you buy one option and sell two options further away.
Can it be in a different ratio?
Yes. A return ratio can be selling two options and buying three options, creating a ratio of 2 to 3. To be a return ratio, you must buy more than you sell.
Can the back ratio option spread profit from FOMC announcements?
Sometimes. The last FOMC statement on December 13, 2023, at 2 p.m. EST, caused a price move large enough for the return ratio to be profitable.
Here’s a 15-minute chart on that day:
Here is a simulation OptionNet Explorer one hour after the opening of the market on that day when the ratio difference could have started:
After the FOMC announcement, an hour before the market closed, the spread was showing good gains:
The day after the split, it looked even better:
Live results may vary from model due to market factors, fill, slippage, commissions, etc.
Can Back Ratio Profit From Earnings Announcements?
Sometimes, if the price moves enough to overcome the volatility that occurs after profits.
After the market closes, Nvidia ( NVDA ) will announce earnings on November 21, 2023.
Let’s say that on that day, a return ratio differential starts:
This time, we use a 2 to 3 ratio by buying three 530 calls and selling two 510 calls – all expiring on December 1st.
The stock didn’t move much:
The next day, depending on when you checked, he could have made a small profit:
But even in a day, the T+0 line has fallen a lot because of the volatility.
In the case of Microsoft (MSFT) earnings, it didn’t work:
Are there other alternatives to spreading the ratio back?
Yes. Other options strategies can benefit from a large move without regard to direction. The spread ratio is not the only thing.
There it is long haired, long strangulationand reverse the iron condor with similar properties to the back ratio spread.
The spread ratio is a good tool to add to your toolbox. Use it when you think there is an important event and you have no idea about the direction.
Although the closing chart can look scary with the Valley of Death, it is less dangerous if you close the spread very quickly before the time decay starts.
We hope you enjoyed this article on aspect ratio selection.
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Disclaimer: The above information is about educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with stock trading options. Any reader interested in this strategy should do their own research and seek advice from a licensed financial advisor.
