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
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.
Let’s say that XYZ stock is trading at $50. You buy 100 shares of stock, buy one 50 call for $4 and sell two 55 calls for $2 each. "Breathing room" shows what your risk/reward in this 1x2 ratio spread looks like at expiration.
Even though the option spread incorporates what appears to be a naked position, there are no uncovered options in the 1x2 when added with the underlying position. The first 55 short call is covered by the stock. The second 55 short call is covered by the long 50 call. You essentially are left with a covered call position combined with a bull call spread. The premium collected on the two 55 calls pays for the premium of the one 50 call.
Let’s look at how the position is affected at expiration in three different scenarios: The stock goes up, goes down or stays flat.
Up: This is where the 1x2 strategy works best. You would now have double leverage on the stock from 50-55. The upside exposure comes from the stock and from the long 50 call. Because we financed the purchase of the 50 call with the two 55 short calls, we gain the same on the call as we do the stock. However, profit is capped at 55 if the stock continues to rally.
Down: Should the stock decrease in value, all the options will expire worthless. Because there was no additional risk added by employing the 1x2 ratio, the risk is present in only the 100 shares of stock you are long.
Sideways: Should the stock stay the same, the options also would expire worthless. It would be a break-even trade (minus commissions).
The above table compares the 1x2 ratio spread to a traditional averaged down position at expiration.
It is important to note that there is time value in those 55 calls. You will not have the double exposure in the 1x2 until expiration. So, like a covered call, if you want the full premium, you must be patient.
This strategy will allow you to grab a little more upside (up to your short calls) without adding additional risk to the downside when a trade intially goes against you.
Mike Tosaw is a portfolio manager at Know Your Options Inc.