Many people are coming to understand the value of option trading, as options lower the capital outlay required, and can increase profits. As traders, new to options, begin to learn about option trading they are usually introduced to credit spreads such as bull put and bear call spreads, Iron Condors, etc.
While the above trades can be good in certain conditions, I would like to teach you a trade I have been using, incorporating ratio spread trading. These trades have better break even prices, have a higher probability of success, and are more easily managed than basic credit spreads. Additionally, it is common to consistently bring in 10% per month, net profits, on a portfolio margined account, and this is using stable ETFs rather than riskier stocks.
In this quick post I will show you exactly what the trade is, using the broad market symbol SPY as an example, and then in the following post I will show you how I manage these trades. My writing is not as much designed to teach theory as it is to present actionable trading ideas.
A ratio spread trade is simply purchasing an out of the money option and selling a higher number of options than you purchased, usually in a ratio of 1X2 or 1X3, etc. I try to do these trades as far out of the money as possible to give myself a better breakeven price and a better probability of success. They can be done with a bullish or bearish bias, or no directional bias (neutral) if preferred.
Here is the profit and loss graph of a bearish (put) ratio spread.
Here is how I constructed the above ratio spread trade:
Buy 2 Jun 136 puts
Sell 4 Jun 135 puts
Total credit of .18
Here are the stats:
Break even: 133.78
Max Profit: 223.53
Probability of success: 96.30%
Margin requirement: $190.09 (on PM account)
Return on Capital: 18.93% or 170.44%/year (assuming 9 cycles)
We could also add a call ratio spread if we wanted to. In doing so, most brokerage firms will not charge additional margin, so the profits (and risk) can be increased.
Obviously this trade has some naked puts, so the usual warnings about not over leveraging apply, as do the cautions about needing to accept naked option risk.
Overall, the ratio spread trade is an excellent trade, especially in times of higher volatility, and can be utilized with success over and over to lower our cost basis of trading on a particular underlying and to create trading profits.
In my next post I will show you ways we can manage this trade, both when it wins and when it loses.
Disclosure: I am long SPY.
Additional disclosure: I have this trade on currently.