Managing Risk with Ratio Spreads

The market is starting to make higher lows and may be showing signs of making a base...at least a temporary one. Ratio spreads may be appropriate in this environment if the following describes you:
You don't want to miss a move upward but think one is coming
Downside risk still makes you nervous
You don't think the market will explode higher

If in fact a short/intermediate term base is forming in the market, consider ratio spreads to profit from it. Below are three examples, based on your risk profile.

This example uses AKS but the strategies can be applied broadly. Firstly, start with a realistic price target. I think by November expiration, AKS could move to the 17ish range but overhead resistance will kick in around 20 (assuming AKS moves up at all!)



















Low Risk (limited, known risk / limited, known profit)
In this example the most you can lose is $180 and the most you can make is $570
This strategy is a Bull Call Spread (you're bullish and it uses calls...if the lexicon is hard to keep straight) but will help illustrate how ratio spreads can be used to adjust your risk/reward.















Medium Risk (opportunity for big profits / unlimited risk)
The risk is technically unlimited with ratio spreads since it does involve the use of naked calls; however, in this example, AKS would have to get above 28 before you started losing some serious money. It's definitely possible but not probabilistic. Plus, the most you can lose to the downside is $195 and if, in fact, AKS moves up moderately, you can make as much as $1,055.















High Risk (the riskiest of the three examples - you won't lose a dime as long as AKS stays under 20 and it has the potential to return some big profits)
If you have high convictions about resistance at 20, consider a higher risk ratio spread. Here, downside risk is zero - you actually get paid $200 to put the trade on. You can make up to $1,475, if AKS moves up moderately (to the 17ish area) but on a move above 20 is where you will get hurt.














Ratio spreads can be a great tool in a time like this. You can see from these examples that it is a constant trade off between how much the ratio spread costs and your chance of success and your upside breakeven point - so a trade calculator as used above is invaluable.

Always make sure you understand the unlimited risk to the upside and continue to be aware of most options currently having a bid/ask that you could drive a bus through. If the spreads are wide, look elsewhere.