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.

SPY - spreads

Suppose you think that SPY is finally ready to break through resistance at 140. Here are a few ways to play it.

First, I'm going to set a realistic price target and then build strategies around it. In this example, I think SPY could realistically get to 144 by June's expiration.


Credit Spread












Debit Spread












Ratio Spread

Longer-term trade suggestions

Quick follow-up to a trade recommendation. From March 8th:
http://optionspot.blogspot.com/2008_03_02_archive.html
SPY APR 143/140 - 116/113
Reward: $670
Risk: $2,330

I think you'll be fine letting everything expire; however, it would be extremely cheap to remove all remaining risk. For example, if you for some reason felt that there was still upside risk at 140 you could liquidate that spread for all of $50 to completely remove the remaining risk of the stock rallying next week. Again, probably not necessary but you will really regret the one time something unexpected happens and you risk $2k for trying to save 50 bucks. Anyway, it's up to you.


Time for another trade suggestion. I hesitate calling this one a recommendation because it's a little more creative and it would freeze up a chunk of capital for a few months. Either way it's a good strategy to be aware of. Here it is:


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.

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.