Facebook
Twitter
As mentioned in our introduction to ratio spread trading, all manner of markets can be exploited using ratio-write strategies. Not only bullish and bearish trends, but sideways drifting markets (lacking volatility) as well as explosively volatile moves can be mapped and harnessed using the appropriate ratio spread.
It’s to the volatile markets that we’re going to turn in this article. Specifically, how to employ ratio spreads under such conditions to produce profits while limiting your upfront costs and muting your risk.
Introducing … The Put Ratio Backspread
Sound complicated?
In theory, it’s rather straightforward, but like all ratio writing, consistent profits are produced via proper planning, experience and, of course, a dash of luck.
Here’s how it’s done.
You sell one in-the-money put and buy two or more at-the-money puts for a net credit. That last detail is important, as it acts as an insurance policy should the underlying fail to move in the explosive manner you expect.
Let’s look at an example to flesh out the details.
This is a chart of the Market Vectors Coal ETF (NYSEArca: KOL), a stock that’s had several fiery outbursts over the years.
Knowing that a vote on new coal legislation is pending any day – and that it will likely result in a significant burst for the sector in one direction or another – you decide in early December to act (in red). You initiate a put ratio backspread because you have a slightly bearish bias for the stock; lawmakers are indicating that the new law will be bad for the industry.
At the same time, you need to know that if your timing is off, or if the anticipated move never actually ensues, you’ll be adequately covered by the initial credit on the trade to avoid a big loss.
With the stock at $24.50, you buy two KOL June $24.50 puts for $3 each and sell one June 27.50 put for $7. Your net credit on the trade is $1.
The Waiting Is the Hardest Part
After nearly two months of sideways to higher action, the bad news finally bites – and the stock careens lower. By the time expiry arrives, KOL is worth precisely $18.50, all your options are deep in the money, and you’re sitting on a very healthy profit.
Here are the numbers:
- Your two long 24.50 puts are worth $6 each.
- Your short 28 put is worth negative $9.
- Your total profit, (including initial credit) is $400 ($1,200 – $900 + $100).
You close out the trade and walk home a winner.
But what if the stock had moved higher? How bad a loss could you have taken?
The worst-case scenario for the trade would have been KOL stalling precisely at the level of your long puts, $24.50. In that scenario, the long side of the trade would have expired worthless, and the short put would have been $3 in the money. Less your initial credit of $1, and you’d be looking at a net setback of $200.
Happy hunting!
The three most profitable days of your life?
On each of these specific days, you could be making thousands of dollars in extra cash. With minimal risk. So get out your calendar…and get ready to step behind the curtain…and into a world of fast, easy money few investors will ever see. Click here to discover it.