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 Quote), which plummeted some 60% when its cancer drug was found less effective than Genetech's(DNA Quote). Shares of Genentech in turn jumped 35% that same day last April. More recently, we have seen Guidant(GDT Quote) 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 Quote) 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.