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.

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