Strategy

Front Ratio Spread

Type of Strategy

trading     /     investing

sentiment

neutral to slightly skewed

implied volatility

high

description

A front ratio spread involves selling more options than are purchased.  The basic ratio spread sells two OTM options for every purchased option closer to the stock price.  SOI recommends against back ratio spreads (purchasing more options than are sold).

A front ratio spread can be considered a purchased put or call debit spread, with an additional short option sold to finance the transaction.  Front ratio spreads are often utilized to purchase or short stock at a beneficial price.

Set-Up

Front ratio spreads can be constructed with either puts or calls.  When constructed with calls, SOI recommends purchasing an additional small delta call to define the unlimited risk potential of a naked call position.

Front ratio spreads should be established for a net credit, eliminating risk in one direction.

Preferred expiration is approximately a 45 DTE cycle, with management occurring at approximately 20 days remaining.

Investors may use ratio spreads for underlying stocks that they wish to purchase or short.  Other strategies that allow for beneficial stock purchases include naked puts, short put spreads, broken heart butterflies, broken wing butterflies, and risk reversals.  All have costs and benefits in relation to each other, with optimal application in a variety of situations based on the holder’s preference.

General set-up parameters are favorable for shorting at 16 delta with a long option at 25 delta.  A second favorable setup involves shorting at 33 delta with a long at 50 delta.  Note, however, that every situation may vary to the standard.

Example – Paypal Holdings, Inc. (PYPL)

Investor wishes to purchase stock in Paypal, but at a price of $190/share or better.  Paypal currently trades at $235/sh.

Front Ratio Put Spread: PYPL

1) The investor elects to establish his spread around shorting two 16 delta options with a long option at 25 delta.

2) In an offensive account (tax-free), sell two 58 DTE, 16 delta short puts at $200 strike price for $3.75 each, or $7.50 total.

3) In an offensive account (tax-free), purchase one 58 DTE, 23 delta long put at $210 strike price for $5.70.

4) Net premium received = $1.80.

5) Max Profit = $11.80  Max Loss = $188.20  (Purchase shares at $188.20)

6) Breakeven Point = $188.20

management

Traders often set a GTC BTC order for 25%-50% of max profit, equivalent to $2.95 – $5.90 in this example.  Investors are more likely to let the trade continue through expiration since stock purchase is a favorable outcome.

Based on stock price movement, the debit spread portion may be closed for near maximum profit.  The remaining short option may be rolled out if required for a credit.