The Incredible Ratio Vertical Spread

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The Incredible Ratio Vertical Spread
Last week I discussed one of my favorite types of trades, the Backspread. This week, I’m going to talk about the other side of that trade, the Ratio Vertical Spread. In other words, if two traders were trading with each other and one put on a Backspread, the other trader would have on a Ratio Vertical Spread.

Obviously, those traders would have very different opinions as to the market at that particular point in time. To be honest, I’m not a great fan of this type of spread, but I want to give you a sense of how to look at the other side of a trade. Also, occasionally this trade does set up nicely, and when it does there are some nice profits to be made.

Let’s start off with a definition:

• Definition: A Ratio Vertical Spread is a delta neutral options position that consists of more short options than long options on the same underlying stock. It can be established with either Calls or Puts in the same expiration month and is sometimes just referred to as a Ratio Call Spread or a Ratio Put Spread, respectively.

There is also a Calendar or Diagonal Ratio Vertical Spread which has more options being sold in a far month than are being bought in a near month. These spreads are not very popular because the margin requirements are quite large. This is due to the fact that the long options would expire before the shorts, and therefore, the shorts are not covered for margin purposes and are considered to be naked.

Skew
As I’ve mentioned in previous articles, since the crash of 1987 most indexes and many stocks trade with a reverse or negative vertical skew. That means that OTM Puts will generally trade with a higher implied volatility (IV) than OTM Calls. This implies that we should sell the lower strike and buy the higher strike. Since we want to make the spread delta neutral, it will set up much better with Puts than with Calls.

To make a Ratio Vertical Spread delta neutral, the ratio of short to long options is usually somewhere in the neighborhood of 2:1 or 3:2. Ratios greater than 3:1 should be avoided. Let’s look at an example of a Ratio Put Spread:

Ratio Put Spread
With XYZ @ $55.30, and
the Oct 50 Put @ $2.80 with a delta of -29, and
the Oct 55 Put @ $4.10 with a delta of -46.

If we sell 30 of the 50’s and buy 20 of the 55’s, we’ll have a position that is net short 50 deltas, which is close enough to be considered delta neutral. It’s calculated as follows:
-30 x -29 + 20 x -46 = -50. Of course if you’re really a stickler you could have used a ratio of 30 to 19 which would have produced a delta of only -4. Now that’s neutral!

Also note, that the net cost of putting on this position is a credit of $200, calculated as
-30 x $280 + 20 x $410 = -$200.

At expiration, the graph of this position will look like this:



Posted By: Stan Freifeld
 
continued in Part Two
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