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Neutral market strategies using options can be implemented in a variety of ways, and with enough know-how, traders can even tailor-make their trades to suit the precise investment landscape they’re trying to exploit.
Indeed, it may be that ratio spread writing offers the most nuanced and flexible trade opportunities to intermediate level options traders trying to profit from an upcoming sideways drift in a stock.
Remember, though, that with ratio writing it’s proper strike selection and the correct long/short ratio that produces maximum profits. And that takes some experience. Have a look at our introduction to ratio spread writing to get a better picture of the fundamentals of ratio writing.
Put Ratio Spread
First of all, let’s establish that a put ratio spread is written with the expectation that the underlying security is about to fall by a very small margin. Indeed, if that happens, profits are maximized.
That said, if the underlying stays put, or even if it rises, there’s still some cash to be had. The only way one can lose money on the trade is if the security decides to defy your analysis and trade steeply lower.
The put ratio spread is therefore classified as a “neutral” trade strategy, as the range in which profits can be had is relatively tight.
Let’s get it on!
The trade is written with two legs:
- The purchase of a single at-the-money put; and
- The sale of two or more out-of-the-money puts. The short puts are best written at the level at which the trader foresees the security declining by expiry.
Before looking at an example, though, a brief digression. I cannot emphasize strongly enough that the ratios and strikes offered here are for the sake of example only, and that profitable, real-world trading decisions may necessitate selecting options that are not reflected in the general explanation that follows.
Let’s turn now to a chart of Tyson Foods (NYSE: TSN) to get a better understanding of the ins and outs of the strategy.
It’s late June and Tyson stock has just exploded for a near 20% gain in 60 days. You like the move, but your research indicates that the buying is now complete and the stock will need to digest the latest gains for roughly the next two months.
So, with the stock trading at $44.50 (red circle), you decide the best course of action is to initiate a put ratio spread, with an expected downside in the $42 range by the time September’s expiry rolls around.
You buy one at-the-money September 44.50 put for $3, and sell three out-of-the-money September 42.00 puts for $1.50 each. Your total credit on the trade is $1.50.
And, indeed, for the next two months Tyson moves sideways, closing at exactly $42 at expiry (blue circle).
It doesn’t get any better…
You nailed it. With the stock at $42, your long put is in the money $2.50, and your short puts expire worthless at the money. Your profit on the trade is a sweet $400 ([$2.50 + $1.50] x 100).
Had the stock closed above $44.50 – as it threatened to do on at least one occasion – you still would have come home with $150 (your initial premium), as all options would have expired out of the money.
Only with Tyson below $40 would you begin to bleed cash. At that level the value of the three short puts ($6) would begin to overtake the value of the long put ($4.50) and the initial premium ($1.50) combined.
Happy trading!
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