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In this installment of our options education series we’re going to look at a trade that’s an amalgam of two strategies we’ve already discussed. Those trades were the ratio call calendar spread and the ratio put calendar spread.
You’ll recall that these trades were built to profit from a brief period of low volatility followed by a burst higher (ratio call calendar spread) or lower (ratio put calendar spread). In both cases, more near-term options were sold than long-term options bought – the idea being to have the former expire out of the money and thereby finance the purchase of the longer-term pair.
The trade is almost always written for a credit, or, at the least, a very small debit.
Combining the Two
But what if you have no bullish or bearish bias for the longer-term course of the stock? What if you’re relatively certain the stock will sleep until the next options expiry, but thereafter will move fast and steep in one direction or another, say, after an important and much anticipated earnings announcement? What strategy does one employ in those circumstances?
Thankfully, the ratio calendar combination exists to address that exact issue.
Simply put, the trade involves writing one call ratio calendar spread and one put ratio calendar spread. And because each is written for a credit (optimally), the cost of the trade remains at or close to nil.
The Nuts and Bolts
Before we delve into the intricacies of the strategy, let’s just review the components – four legs in all – in order to enhance our appreciation of the “live” example that follows.
Ratio call calendar spread:
- Sell three near-term at-the-money calls; and
- Purchase two longer-term at-the-money calls.
Ratio put calendar spread:
- Sell three near-term at-the-money puts; and
- Purchase two longer-term at-the-money puts.
The only other detail to remember is that the strike price of the calls must be higher than those of the puts.
Now let’s turn to the charts. This is six months’ worth of trade in Wal-Mart (NYSE: WMT):
It’s now July and there’s employee relations news due on the company sometime in late fall. Most analysts are convinced the stock will move on the news, but no one is sure which way. The company, too, is being guarded about offering guidance. In short, anything is possible.
In order to capitalize on the situation, you open a ratio calendar combination. With the stock just under $76 (red circle), you sell three August 77 calls for $2 each and buy two November 77 calls for $2.90 apiece. On the call side, your credit is $0.20.
On the put side, you sell three August 75 puts for $2.25 each and buy two November 75 puts for $3.25 each. Total credit here is $0.25, for a total premium of $0.45 on the trade.
Time Marches On
By the August expiration, the stock is a tad lower, but is still situated between the two strikes of 75 and 77 (blue circle). All the short options expire worthless, and you’re left with a no-cost ride in either direction – almost guaranteed to produce profits so long as the expected “big” move occurs.
And it does!
After a brief head-fake lower in October, Wal-Mart stock rockets to $85 by November expiry. Your long put expires worthless, but your call lands $8 deep in the money. Total profit on the trade is $845 ([$8 + $0.45] x 100).
Potential Downside
There are too many permutations to offer a true break-even for the trade, but the worst-case result occurs if, contrary to expectations, the stock moves wildly at the outset, then drifts sideways at the end. Under such a scenario, a massive loss would be sustained on the three short in-the-money options while no gain would accrue from the two longs.
For that reason alone, one should consider closing out all short positions that move into the money.
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