Question:
How do you get unlimited profit potential and reduce your initial cost to do so?
Answer:
A 2-to-1 ratio spread.
A two-to-one ratio spread is primarily used when you have at least 90 days until expiration, where you have a known risk if wron
g and unknown reward if right.
In the case of a ratio call spread; this would be the same as a short vertical call spread and a long call.
The goal is to have an unlimited profit potential, but at the same time reduce the cost of ownership of the outright call, reduce the cost of time decay, and lose a fraction of what would be lost if wrong and having just a long call position.
If you already know what a vertical call spread is, the rest is easy. Briefly, a vertical call spread is buying one strike and selling another strike with the same expiration date. If you buy the spread, you pay the premium and that is the total risk. If right in the case of a call spread, you want the futures price to be above the strike you sold so the spread expires at full value.
When you buy a ratio spread you are buying two call options above the strike you sell. You are expecting the market to go higher, and if wrong, lose less than spending the same amount as an outright call for the same premium. It also slows down the amount gained or lost on a daily basis. If there is an explosion in price to the upside, this spread should gain more than an out-of-the-money option of the same premium. With the long time frame, options will move in tandem. In this case, the lower strike moves more than the higher strike. The market can go against you significantly in the near term without forcing you to get out.
The soybean market could go much higher by August because even if the bullish fundamentals wane, Mother Nature could step in and drive prices higher. Options with that much time are expensive to own for an unlimited profit potential. Here is one way to overcome some of that cost of participation.
On March 28, the soybean market for November 2008 futures contract settled at $11.5950. The $12 call settled at $1.37, and the $13 call settled at $1.0475. The ratio call spread would be buying two $13 calls and selling one $12 call.