Question: How can you add protection to a short option position and still profit while extending opportunity?
Answer: The ratio credit spread
In today’s volatile markets it is wise to add an extra layer of protection to your option selling trades. An effective tool for this is the ratio credit spread. Also known simply as a ratio spread, this strategy offers a layer of protection along with the ability to profit more if the market moves against your short options. The basic concept involves selling out-of-the-money naked options and using part of the premium collected to buy a close to, or at-the-money option. The premium left over is called the credit. The number of options sold vs. the amount purchased is the ratio. Thus, if you sold three options for every option that you purchased, the ratio would be 3:1. If all of the options involved expire worthless, the trader’s profit will be the net credit he received after paying transaction costs.
The benefits are threefold:
- By purchasing a near- or at-the-money option, a trader adds a strong layer of protection to his short option position. The long option covers, at least partially, the short option position. Therefore, in volatile markets, a move against the short option position will be offset at least partially by a profit from the long option. And as a move against a naked short option can mean increasing margin requirements, a profitable long option also will minimize, if not entirely offset, this margin increase. The credit spread can stabilize an account with smaller swings in equity and margin requirements in adverse market conditions.
- The second benefit of a credit spread is the opportunity for increased profits beyond net premium collected from the short options. If the price of the underlying contract expires between the strikes of the long and short options, a trader profits not only from the premium collected on the short options, but also from the long option expiring in-the-money.
- The third benefit is staying power. Because of the offsetting effect this long option has on short option values and margins, it allows a trader to withstand adverse moves against the position, even more so than selling far out-of-the-money naked options. If the trader ultimately is correct, he can withstand a significant short-term price fluctuation while remaining in the trade.
At some point, of course, the losses from the short options will exceed the rate at which the long option can counterbalance them. This loss rate is maximized once the short options go in-the-money (if held that long). However, losses would be smaller and accrue more slowly than if the options simply were sold naked.
There is no one correct formula for how many options to sell vs. how many to buy. Trading the spread more aggressively generally means collecting a larger credit and buying less protection. Conservative traders would buy more protection.