From the March 01, 2012 issue of Futures Magazine • Subscribe!

Establishing an option put ratio back spread

Options Strategy

Let’s take a look at IBM’s pricing. With the stock trading at $192.95, the July 170 puts, which are $22.95 out-of-the-money, are trading at $3.50. The July 215 calls, which are $22.05 out-of-the-money, are trading at $2.00. This means that IBM options are positively skewed to the downside and negatively skewed to the upside; 99% of stocks are skewed that way. Options on agricultural futures usually are positively skewed to the upside and flat or negative to the downside.

When the trader is constructing an initial position, being net long puts makes sense. Going long three of the July 170 puts at $3.50 and short two of the July 180 puts at $5.60 is a good example. If IBM closes at the July expiration at $180 or above the trader profits 70¢($70). No harm, no foul. If IBM closes at $170, the trader loses $17.30 ($1,730). That’s a fair amount of harm for a simple 3x2 spread. If IBM closes at $150, the trader is back to the 70¢ profit. Below that price point is all gravy. There is almost a 30-point range where the put back spread is unprofitable.

That, however, is taking into account only what happens to the untouched position at expiration. While 10% of profits usually are derived from establishing a sensible initial position, the other 90% comes from knowing how, when and why to adjust that position.

With this position, if the stock starts heading south, the position instantly will become profitable. The implied volatility for all options will increase with a sharp downside move. Because the trader has a net positive inventory of put options, that inventory will be priced higher. The trader then either can unwind the position for a profit or adjust it by selling some puts at a much higher implied volatility. Buying low and selling high works the same for implied volatility as it does for market direction.

Dan Keegan is an instructor with the Chicago School of Trading. Reach him at dan@thechicagoschooloftrading.com.

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