Ratio Spreads Offer a Volatility Play
After scanning through option chains, biotech and oil currently are the most fertile sectors for ratio spreads, with many individual stocks whose options have a vertical skew and therefore present an opportunity for establishing even-money ratio spreads. But biotechs are like the Internet stocks of the late 1990s. They have high implied volatilities for a reason; a decision on a drug by the FDA can cause prices to move 20% or more in a single day.
Recent examples include Biogen (BIIB), which plummeted some 60% when its cancer drug was found less effective than Genetech's (DNA). Shares of Genentech in turn jumped 35% that same day last April. More recently, we have seen Guidant (GDT) tumble 12% in a day on concerns regarding the safety of its heart device. These sudden moves can wreak havoc on a ratio spread.
That's why I'm focusing on the energy stocks and in particular believe Valero (VLO) is a good example of a candidate for a ratio call spread. The oil stock has recently stumbled, down some 18% over the past three weeks to its current $95 level, but the chart shows good support around $90 per share. The implied volatility meanwhile has increased from 38% to 51%, to a new 52-week high, during the past two weeks.With shares of Valero trading at $96, one could buy the November $95 call for around $6.20 per contract and sell November $105 calls for around $2.60. Traders can use a 1:2 ratio spread, buying one November $95 call and selling two of the $105 calls for a net debit of $1.00. The cost of the spread represents the maximum loss should the shares decline below $95 and all the options expire worthless. The maximum profit of $9 per spread is achieved if Valero is at $105 on the Nov. 18 expiration day. The important thing to keep in mind is that once the shares rise above the $114 break-even point, the positions become outright short and the risk is theoretically unlimited. Ratio spreads are a valuable strategy for taking advantage of high-volatility situations, but use them with care.
Select the service that is right for you!COMPARE ALL SERVICES
Jim Cramer and Stephanie Link actively manage a real portfolio and reveal their money management tactics while giving advanced notice before every trade.
- $2.5+ million portfolio
- Large-cap and dividend focus
- Intraday trade alerts from Cramer
- Weekly roundups
Access the tool that DOMINATES the Russell 2000 and the S&P 500.
- Buy, hold, or sell recommendations for over 4,300 stocks
- Unlimited research reports on your favorite stocks
- A custom stock screener
- Upgrade/downgrade alerts
Jim Cramer's protege, David Peltier, identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.
- Diversified model portfolio of dividend stocks
- Alerts when market news affect the portfolio
- Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
All of Real Money, plus 15 more of Wall Street's sharpest minds delivering actionable trading ideas, a comprehensive look at the market, and fundamental and technical analysis.
- Real Money + Doug Kass Plus 15 more Wall Street Pros
- Intraday commentary & news
- Ultra-actionable trading ideas
Our options trading pros provide daily market commentary and over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.
- 100+ monthly options trading ideas
- Actionable options commentary & news
- Real-time trading community
- Options TV