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Ratio Spreads Offer a Volatility Play

This option strategy can be used by experienced traders to great effect in volatile times.

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




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.

Striking a Balance

In writing a ratio spread, one wants to take advantage of high implied volatilities.

High-volatility stocks typically have what is called a "vertical skew," meaning the implied volatilities move higher as you go up the strike-price chain. In a normal skew, the lower options with lower strike prices typically have a higher implied volatility. Stocks with vertical skews make it easier to set up a zero-premium ratio spread.

However, ratio spreads should only be used by experienced options traders and written in stocks with which they have a high comfort level, confidence in the trading pattern and in situations in which they're willing to take on some risk. This is because ratio spreads have a fairly high gamma, meaning the position's delta is highly sensitive to the price movement in the underlying security. (The delta shows how much the option will change in price as the underlying asset changes in price. Gamma shows how much the option's delta will change as the underlying asset changes in price.)

Unlike a 1-to-1 spread, in which the directional bias remains constant, a ratio spread position will actually swing from being long to short as the underlying price moves higher.

Furthermore, a ratio spread might involve buying one contract of a specified strike and selling two, three or even four contracts of a higher strike. Keep in mind, the higher the ratio, the steeper the loss line will be once the price passes the higher strike.

The key is to find a balance between reducing your cost and multiplying your risk. The goal is to bring the total cost of the spread close to zero by using options that have the greatest separation between strike prices, but require the lowest ratio.

For example, assume shares of XYZ were trading at $50. An even-money spread consisting of buying one $50 call and selling two $50 calls for even money is more attractive than buying one $45 call and selling three $55 calls for even money.

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


(BIIB) - Get Free Report

, which plummeted some 60% when its cancer drug was found less effective than



. Shares of Genentech in turn jumped 35% that same day last April. More recently, we have seen



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


(VLO) - Get Free Report

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 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;

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