Facebook
Twitter
Diagonal ratio spreads are just like their vanilla diagonal spread cousins, except the number of near- and long-term options employed is unequal.
So, whereas a diagonal spread is composed of one near-term short call (or put) and one longer- term long call (or put) with different strike prices and different expiries, the ratio spread version might sell three of the former and buy just two of the latter.
The spread is executed for a net credit (or, at the very least, a very small debit), and stands to maximize profits if and when the near-term options expire worthless before a big move in the underlying sends the long option deep in the money.
The trade is therefore not easily classified, as it’s both a neutral and directional trading strategy. It aims, at first, to profit from a lack of volatility, and thereafter from a strong move in the underlying.
Gun Maker Loads and Fires
Let’s look at a case study now, using shares of gun maker Sturm, Ruger & Co. (NYSE: RGR) to help us flesh out the call diagonal ratio spread strategy:
It’s now mid-May, and shares of Ruger have drifted in the $50 range for a few months. You expect the action to continue through the summer, but after that, your research indicates that a number of new company developments and a production facility upgrade could spur the shares much higher.
Your first impulse is to buy long-dated call options, but you’re worried about price, and if the expected move doesn’t transpire, you don’t like the prospect of losing such a big chunk of change.
Playing the Calendar
After discussing it with your broker, you decide on a call diagonal ratio spread strategy. So long as the shares are drifting, he says, why not profit from the inertia by selling some premium, and then use those same funds to finance the purchase of the longer-term calls?
Genius.
You line up your cash and dive in (red circle).
For the short leg, you sell four near-month, at-the-money calls – the RGR June 52 calls to be precise – for $1.50 each, netting you $6 in premium.
On the long side, you buy two RGR September 55 calls for $2.80 each. Your net credit on the trade is $0.40.
And as you expected, the stock drifts.
By the June expiry, RGR is trading at $49, your short calls expire worthless, and you’re looking at a free ride into the September expiry with $40 cash in hand.
The Final Tally
Six weeks later, the stock is still locked in a range, but come Labor Day she pops faster than a speeding bullet. And when September expiry hits, it’s a bull’s-eye on $62.
Your profit is a fine $740 ([$62 – $55 + $0.40] x 100). Congratulations.
As for potential losses and break-even points, calculating them honestly is all but impossible with two separate expiries. The worst-case scenario for the trade involves:
- A steep climb at the outset that would put the short calls deep in the money, followed by…
- A decline below the strike of the long calls, at which point they would expire worthless.
It’s therefore very important to close out all trades before they become runaway losses.
Trading Note: It’s also possible to sell calls monthly against the open long position for additional premium.
A 95% Success Rate
It’s as close to perfect as anything you’ll find in this world. It’s the ultimate trading system—one handing you double-digit returns in just seven days. In and out. Just like that. It’s the fastest, easiest money you’ll ever see. Find out how right here.