Ratio Spreads Offer a Volatility Play

One of the great conundrums of options trading is the fact that you are working with an eroding asset.

The attraction of selling premium and letting the time decay work in your favor is both seductive and dangerous; statistics show that some 80% of all options expire worthless, but the 20% that do make it "into the money" usually deliver a high percentage return to their owners.

The tales of pain and loss inflicted on those who've been lured by the siren song of selling an inherently worthless item -- yet find themselves standing with a naked short-option position -- are best told after sufficient time and whiskey allow the wounds to heal.

Of course, simply paying to own options has drawbacks, too. Sure, option ownership provides limited risk, but it isn't easy to watch your money drip away while the clock ticks and you're hoping the stock moves enough before time expires to yield a profit.

So what is the option trader to do, especially during times of rising stock-market volatility such as we are now experiencing. The implied volatility of the S&P 500 index options, as measured by the VIX, has risen 27% to a new six-month high over the last three weeks. According to data from McMillan Research, an options research and investment firm, nearly 45% of all optionable NYSE- and Nasdaq-traded stocks have options whose implied volatility is above their 52-week averages, and that is the highest percentage at that level in more than a year.

Ratio spreads are one alternative, as they offer a nice balance between straight net debit and net credit positions. Ratios are similar to straight vertical spreads, where you buy one strike and sell another that is further out of the money on a 1-to-1 basis. But with a ratio spread, you short a multiple amount of the higher strike, the goal being to reduce the total cost of the spread while maintaining a reasonable risk/reward profile. In both cases, all strikes must have the same expiration. The concept behind a ratio spread is that one is selling options that are relatively more expensive than the options one is buying.