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A ratio calendar spread carries unlimited profit potential, limited risk and is similar in structure to a traditional calendar spread.
What separates the strategy from a straightforward calendar spread is the number of options traded. With a ratio calendar spread, one sells a greater number of near term options than long term options purchased. The rationale behind the trade is that the short options will expire worthless and end up footing the bill for the longer-term options.
The strategy can be employed using either puts or calls and is best initiated when traders expect little volatility over the near term, followed by a stronger move into the longer maturing expiry.
In this article we’re going to examine the put variety of the ratio calendar spread, and we’ll do that by turning directly to a live example to get a better idea of the risks and rewards for the trade.
Below is a chart of HP Inc. (NYSE: HPQ) – formerly Hewlett-Packard Co. – for a six-month duration:
After a steep drop into late August, HP bounces and starts to drift sideways. You’re not impressed with the company’s numbers and expect a further decline, but after the recent bloodletting, you don’t expect the next move lower to be imminent.
You figure your best bet is a ratio calendar put spread, a strategy that will more or less pay for itself – and, at the same time, minimize any potential loss should the move take longer to materialize than you expect.
So you do it.
It’s the first week of September, the stock is at $12.50, and you’re on the phone with your broker, selling three at-the-money HPQ October 12.50 puts for $2.50 each and buying two HPQ January 12.50 puts for $3.50 apiece (red circle). Your credit on the trade is $0.50.
And the stock drifts…
After an initial drop to $11.00 that scares the porpoise right out of you, HP moves sideways to slightly higher by the time the first expiry hits, closing at $12.75 on the third Friday of October (black circle).
You’re thrilled. The three short puts expire worthless, and your profit potential is now theoretically unlimited.
Theoretically.
In reality, January’s expiry sees a steady decline down to $9.75. The long puts expire in-the-money $2.75 each, offering you a net gain of $600, including the initial credit.
Alternative Endings
There are too many possible loss scenarios to outline here. Suffice to say that the worst case would occur if the short puts ended deep in the money at the first expiration, then the stock broke wildly higher to close above $12.50 by the latter. In that case, your loss would be extraordinary on the short leg, alongside a gain of nil on the second. And the only thing mitigating your loss would be that initial $50 credit.
Final trading note: Another advantage of the strategy is the ability of the trader to sell additional premium in the months leading up to the long options’ expiry. In this manner he both augments the potential profit on the trade and, at the same time, provides himself with a bigger downside cushion should the stock move against him.
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.