Decades ago, when a 5% move in a day or few was a mere 5 to 10 S&P 500 points, I used to trade ratio spreads. This was a lucrative options trading tactic that created nice profits with low risk that was 100% controlled, in spite of the fact that the tactic begged to be one of negative gamma. As the market began to climb in value that reliable low-dollar risk of 5% became a much more serious dollar/capital risk. With that growing capital risk, I stopped doing ratio spreads.
With the recent advent of CBOE mini options things might revert back to ratio spreading once again being efficacious relative to capital risk, because the risk of 10% of 100 shares (10 shares) using mini options is enticing relative to the dollar risk for the ratio spreader. Thus ratio spreading minis should create a sort of back-to-the-future opportunity.
Ratio spreading is the spreading of options where the total of long and short options is not an equal amount. One very basic ratio spread is colloquially labeled as the one-by-two spread. 1X2 refers to a ratio spread which has the one being the long side of the ratio spread, while the two is the shorted side of the ratio spread. However, I prefer the 1X2X1 tactic as that type of combination controls risk 100%.
An example could be Apple(AAPL) trading at say $460:
Buy 1 October 450 mini call for $42, sell 2 October 500 mini calls at $22.50 and buy 1 October 625 mini call for $3.00.
This 1X2X1 would make a profit on October expiration if AAPL was $550 to $450. The long 625 call is the upside stop-out should AAPL return to its mega-bullish days of a year or so ago. If AAPL expires below $450 the spread would break even. Should AAPL expire on or near $500 that would be the maximum profit level of this three-way ratio spread as the shorted 500 strike would expire at zero, generating the vast majority of the profit. This AAPL ratio spread's 1x2x1 gain with that 500 level expiry would return 50 points of profit while have used a net 0 points of capital (plus the required margin). The math is as follows:
With Apple at 500 on October expiration, the one long 450 call would gain $8. The two short 500 calls would gain $45 (22.50 times 2 = 45). The one long 625 call would lose $3. Thus: +8 + 45 - 3 = +50 points.
Without the long 625 call the spread would be one of negative gamma with unlimited risk. That type of ratio spread, the 1X2, is one of negative gamma. The phrase negative gamma should always send the alert signal to the options trader as being a tactic that entails unlimited risk if ratio spreading calls and very serious capital risk if ratio spreading puts. I have a very sensitive aversion to negative gamma. Thus, I never allow for a position that could possibly have unlimited risk as those best laid options plans can and will go awry.
Once mini options pass muster during the break-in phase I will write much more in depth about various ratio spreading options trading approaches. Until then we watch and learn as the mini options markets trade, always seeking an edge while doing so!
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