Ratio Spreads Offer a Volatility Play

The Candidate

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.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback; click here to send him an email.

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