Tuesday, April 1, 2008

Ratio Spread

Suppose that you thought by July, (AAPL) would be trading at a maximum of 195 but didn't want to take on any downside risk in case Armageddon is just around the corner.

An alternative to buying calls, for example, would be a ratio spread. This is a strategy where you think the stock (in this case AAPL) will go up x% but not y%, where x is maybe 30% and y is 50%. Click on the graph to the right. I have identified a possible price target for AAPL by July. In this example, I think AAPL has the potential to go to the 180-200 range but not above the 210 range.

Some advantages include no outlay of capital and the potential to profit from a move up, sideways or down.

Disadvantages include sacrificing some potential upside, having to tie up a chunk of capital, and getting burned if the stock were to shoot to the moon.

Here is the trade calculator: You can see that you will receive a $134 credit for putting on the trade and if, near expiration, the price shoots up to 185ish, you have the ability to make over 2k but will begin to lose above $205. Due to the 2 naked calls involved, losses are technically unlimited so there is certainly risk involved.
At my brokerage, due to the naked calls, I would be required to keep $3,400 in my account as collateral. Like credit spreads, iron condors, etc. this would be a bet on probability.

Here is a similar example using October as the expiration month but using the same strikes.

Ratio spreads make great trade adjustments but can also be used to initiate a trade. Regardless of what strategy you prefer I think it's important to consider some longer term trades. Short-term trading has been extremely difficult and dangerous for the last few months.

I would continue looking for deep OTM credit spreads or iron condors to sell. I would also recommend looking at some big names like AAPL, GS, USO, RIMM, SMH, XLE, XLF, etc. and make some spec. bets on where they might be 6 to 10 months down the road. This market, while currently discouraging, is presenting some great opportunities.

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