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.
For example, a trader who is neutral to bullish the crude oil market wants to sell puts below the market. He elects to sell the December 55 crude oil put because although he is not sure where prices will be at expiration, he is confident that they still will be above $55 per barrel. The trader sells 3 December 55 crude oil puts for $950 each for a total premium of $2,850. He takes a portion of the premium and buys 1 December 60 put for $1,400. His credit is as follows: $2,850 – $1,400 = $1,450.
As long as crude does not tank below $60, all options expire worthless and the trade earns $1,450. If the crude market moves lower, but remains above $55, the profits could be higher.
For instance, suppose on option expiration day, December crude is trading at $58. The 55 puts would expire worthless ($2,850 profit). The 60 put would expire $2 in-the-money, and be worth $2,000. If the cost of purchasing this option ($1,400) is subtracted, it nets a profit of $600. Therefore, the net profit on the trade would be $3,450 ($2,850 + $600 = $3,450).
If the price is nowhere close to your strikes, you can sell the protective put as the options near expiration and recoup several hundred dollars while the remaining short safely expires worthless.
Risks on a ratio credit spread, like futures trading or naked option selling, can be unlimited once the underlying contract exceeds the short option strike. Although a ratio credit spread still can be profitable beyond the short option strike price, it generally is a good idea to exit the position after the strike price of the short options is reached. After this level is exceeded, profits can begin to deteriorate and losses can begin to accrue quickly.
James Cordier & Michael Gross are authors of “The Complete Guide to Option Selling” 2nd Edition (McGraw-Hill 2009). They are co-portfolio managers of OptionSellers.com, an investment firm that offers managed option selling portfolios.