Ratio & Back Spreads

By: Don Fishback

The following is an excerpt from Don Fishback's Options Wizardry Profit Alert

When the number of options that you buy in a spread differs from the number of option sold, you have a ratio spread.

Call Ratio Spread

In a call ratio spread, you typically buy one put at a lower strike price and sell two calls at a higher strike price.  The premium received from the sale of the two calls will sharply reduce the net cost of the closer-to-the money option or may even yield a net credit.  The positions have unlimited risk if the underlying market explodes through the short strike price.

For example, assume that you are establishing a call ratio spread in June 490, 520 Google call options and want to receive a credit of at least 6.1 per spread.  The 490 call traded last at 3.8; the 520 call at 8.8.

To enter a Call Ratio Spread Order you would need to provide the following information:

1.

Account Number:

12345

2.

Market Action:

Buy/Sell

3.

Quantity:

2/3

4.

Month & Year:

June 20, 20_

5.

Contract:

GOOG 490 c
GOOG 520c

6.

Order Type:

Limit

7.

Open or Close:

Open

8.

Price:

6.1

Enter the order as follows:

ACCOUNT 12345
BUY 2 JUN 490 GOOG CALLS to OPEN
SELL 3 JUN 520 GOOG CALLS to OPEN
at 6.1 CREDIT

This order, entered as a spread, must be filled as a spread and generate a minimum credit of 6.1 because it was entered as a limit order.  The spread was trading at 5 when the order was entered which means that you may or may not get filled on all or any at 6.1.  When liquidating the option, the orders can go in as spreads or as individual options.

520 Strike

Sell 3 Calls

530 Strike

 

520 Strike

 

510 Strike

 

500 Strike

 

490 Strike

Buy 2 Calls

Put Ratio Spread

In a put ratio spread you typically buy one put at a higher strike price and sell two puts at a lower strike price.  The premium received from the sale of the two puts will sharply reduce the net cost of the closer-to-the-money option or may even yield a net credit.  These positions have unlimited risk if the underlying market drops sharply through the short strike price.

For example, assume that you are establishing a put ratio spread in June 460, 470 Google options and want to receive a credit of at least 6 per spread.  The 460 put traded last at 10.2; the 470 put at 14.4.  The spread is trading at 5.2 but you are willing to let the order work for several days.

To enter a Put Ratio Spread Order you would need to provide the following information:

1.

Account Number:

12345

2.

Market Action:

Buy/Sell

3.

Quantity:

½

4.

Month & Year:

June 20, 20_

5.

Contract:

GOOG 470p
GOOG 460p

6.

Order Type:

Limit Open Order (GTC)

7.

Open or Close:

Open

8.

Price:

6

Enter the order as follows:

ACCOUNT 12345
BUY 1 JUN 470 GOOG PUTS to OPEN
SELL 2 JUN 460 GOOG PUTS to OPEN
at 6 CREDIT OPEN ORDER (GTC)

This order, entered as a spread, must be filled as a spread and generate a minimum credit of 6 because it was entered as a limit order.  The spread was trading at 5.2 when the order was entered which means that you may get filled on only one spread, or none, at 6.  When liquidating the position the orders can go in as spreads or as individual options.

Back Spread

A strategy in which you buy more options than you sell, the opposite of call and put ratio spreads, is a back spread.  In a call back spread you typically sell one call with a lower strike price and buy two calls with a higher strike price.  Maximum loss occurs if the underlying equity is exactly at the higher strike at option expiration.  In a put back spread you typically sell one put with a higher strike price and buy two puts with a lower strike price.  Maximum loss occurs if the underlying equity is exactly at the lower strike at option expiration.  These positions have limited risk and unlimited profit potential.  And, if the position is established at a net credit, you have the opportunity to profit no matter which way the underlying market moves.

As an example of a call back spread, assume that you are spreading the May 129, May 130 DIA calls and are anxious to establish the position.  The 129 calls traded last at 4; the 130 calls at 1.

To enter a Call Back Spread Order you would need to provide the following information:

1.

Account Number:

12345

2.

Market Action:

Buy/Sell

3.

Quantity:

½

4.

Month & Year:

May 20, 20_

5.

Contract:

DIA 129c
DIA 130c

6.

Order Type:

Market

7.

Open or Close:

Open

Enter the order as follows:

ACCOUNT 12345
BUY 2 MAY 130 DIA CALLS to OPEN
SELL 1 MAY 129 CALL to OPEN
MARKET

This order, entered as a spread, must be filled as a spread.  You know that the order was filled because it went in as a Market Order.  We can not be sure of the price for the spread, but it was trading at 2 debit when the order was entered (sell 1 @ 4; buy 2 @ 1 each = 2).  When liquidating the position the order can go in as spreads or as individual options.

130

Buy 2 Calls

129

Sell 1 Call

128

Current Price Underlying Market

127