From the September 01, 2011 issue of Futures Magazine • Subscribe!

Using a 1x2 options ratio spread

Options Strategy

Question: How do you maintain a long position that is going against you because of choppy conditions?

Answer: A 1x2 ratio spread allows you to cost average cheaply.

When the equity and commodity markets get choppy, traders and investors begin to look for strategies to help navigate the chop. One strategy to consider is the 1x2 ratio spread. In some cases the 1x2 allows you to cost average into a position cheaply, and in other cases you can get paid to cost average into a position.

The official definition of dollar cost averaging is to allocate a set amount of money to a set asset for a set period of time. For instance, you could buy $500 of XYZ stock every three months. Regardless of where XYZ trades, you buy a set amount. You would purchase more shares if the stock is near its 52-week low, and less stock if it is near its 52-week high (this should be based on a long-term outlook rather than simply adding to a loser because you refuse to admit you are wrong).

If you buy 100 shares of XYZ at $50 per share, your risk is $5,000. If it goes down to $40, and you buy another 100 shares, you now have an average cost basis of $45 per share. The advantage is the lower break-even point. The disadvantage is the added risk; 200 shares at an average of $45 is $9,000. This isn’t dollar cost averaging, but rather averaging down your cost basis.

Averaging down is a concept that traders employ to try to capture a shorter-term up move in a position that has turned against them, yet they still feel has upside potential. Rather than putting the extra dollars at risk, averaging down can be accomplished by employing an options strategy called the 1x2
ratio spread.

It often is assumed that a spread involves buying and selling an equal number of contracts, but that is not always the case. A ratio spread is when the number of calls or puts that you are buying is different from the number that you are selling within the spread. When you buy more than you sell, it is considered a back spread. When you sell more than you buy, it is considered a front spread. The 1x2 ratio combines a front spread with an underlying stock position.

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