From the May 01, 2008 issue of Futures Magazine • Subscribe!

Using a 2-to-1 ratio spread

Question: How do you get unlimited profit potential and reduce your initial cost to do so?

Answer: A 2-to-1 ratio spread.

A two-to-one ratio spread is primarily used when you have at least 90 days until expiration, where you have a known risk if wrong and unknown reward if right. In the case of a ratio call spread; this would be the same as a short vertical call spread and a long call.

The goal is to have an unlimited profit potential, but at the same time reduce the cost of ownership of the outright call, reduce the cost of time decay, and lose a fraction of what would be lost if wrong and having just a long call position.

If you already know what a vertical call spread is, the rest is easy. Briefly, a vertical call spread is buying one strike and selling another strike with the same expiration date. If you buy the spread, you pay the premium and that is the total risk. If right in the case of a call spread, you want the futures price to be above the strike you sold so the spread expires at full value.

When you buy a ratio spread you are buying two call options above the strike you sell. You are expecting the market to go higher, and if wrong, lose less than spending the same amount as an outright call for the same premium. It also slows down the amount gained or lost on a daily basis. If there is an explosion in price to the upside, this spread should gain more than an out-of-the-money option of the same premium. With the long time frame, options will move in tandem. In this case, the lower strike moves more than the higher strike. The market can go against you significantly in the near term without forcing you to get out.

The soybean market could go much higher by August because even if the bullish fundamentals wane, Mother Nature could step in and drive prices higher. Options with that much time are expensive to own for an unlimited profit potential. Here is one way to overcome some of that cost of participation.

On March 28, the soybean market for November 2008 futures contract settled at $11.5950. The $12 call settled at $1.37, and the $13 call settled at $1.0475. The ratio call spread would be buying two $13 calls and selling one $12 call.

• Buy two $13 calls at $1.0475 each = $2.0950 (-) selling one $12 call at $1.37. You would pay 72.5¢ if you were buying the spread. (Each 1¢ on the spread is worth $50.)

If you held the spread until expiration, you would lose the entire 72.5¢ if the market settles below $12. If at $13 you would also lose the $1 differential on the vertical. This would be expensive and not worth the risk of ownership. But if soybeans were trading at $16, the $12 call is protected by one of your $13 calls, so that would be $1 against you and the other $13 call is worth $3:

• $3-$1=$2 - 72.5¢ = $1.275 profit.

However, ratio spreads for the most part aren’t meant to be held until expiration. This strategy provides a way to own premium for less money, and to make money if the market goes up and not have a wasting asset. Normally you will hold these positions for 40 to 60 days before getting out or morphing into another strategy.

With 90 days or more until expiration, the two strikes will move in tandem, with the lower strike moving slightly more than the higher strike.

What you are looking for in this strategy is for the market to move up no matter how fast or slow (fast is better) with plenty of time left, and this strategy will pay off nicely. How? The options for November expire on Oct. 24, and if the market rallies, the options should increase in value, especially if they go intrinsic and your two $13 calls should increase in value more than the $12 call. If the market rallies, the premium of every option should increase, and the $13 calls should start acting more like the $12 call.

You could just take the 72.5¢ and buy a call. On Thursday you could have bought a November $15.80 call for about 72¢ and on Friday it settled at 63.625¢. This outright will not protect you like the ratio will from time decay, and it buys you the right to be long from $15.80 instead of from $13. At $16 the $15.80 option would be worth only 20¢ on expiration and the ratio as explained above would profit for $1.275.

This strategy, like all option strategies, can be put on and taken off as a whole or in part at any time. If the market rallied sharply and you wanted to take profit, you simply would sell one of the $13 calls and stay short the $12 to $13 call spread and know what the risk reward is at all times with that short position.

With added volatility, it is easy to be right but still get stopped out of a position. The ratio spread allows time for your strategy to play out.

Howard Tyllas is registered with the CFTC as a floor broker and CTA. He’s a member of NFA and a veteran trader of 31 years. He has traded options on futures since their inception.

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