Ratio Option Spreads- A Play For Soon To Be Volatile Markets

Options are incredible market tools. They allow for investors and traders to gain enormous leverage in markets. Options are the only instruments that give market participants the opportunity to make money in a market going higher, going lower or not moving at all.

Options are, at their very core, tools that reflect the volatility of markets. In the world of raw materials, options are particularly useful as commodities are one of, if not the most volatile asset class.

Options are price insurance, buyers of options are the insured and sellers of options act as the insurance company.

Call and put options complement each other. A call gives the buyer the right to buy while the put gives the buyer the right to sell. Many options traders construct market positions using a combination of options. A popular trade is the ratio option spread. Options with strike prices that are close to the current market price have higher prices, or premiums, than those that are further away from the current market price. For example, a call option on crude oil with the right to buy oil at $34 in three months when the price of the energy commodity is $30 per barrel, is more expensive than a call option with the right to buy at $50 for the same period. Let us say that the $34 call option for expiration in three months is $5. At the same time, the $50 call option for the same expiration may be $0.50.

In this example, if you were to sell one $34 call option, you could buy up to ten $50 call options for no premium. The $5 received for the sale of one $34 call would offset the $5 paid for the purchase of ten $50 call options at 50 cents each. If crude oil were to go to $100 over the life of the spread, the net result of the trade would be a profit of $434 per barrel of spreads transacted.

You would lose $66 on the $34 call option sold, but at the same time, the profit on the ten $50 call options purchased would be $500 per barrel (ten times $50). The maximum loss on this trade would be $16 per barrel if crude were to go to $50 on expiration. However, the upside on the trade is unlimited. If oil moved to $150 per barrel before expiration, this trade would result in a profit of $884 per barrel of spreads transacted. Additionally, these spreads could also be effective on the downside when one thinks a market is moving much lower. Selling a nearby put option and buying a ratio of put options further away from the current market price with the same expiration could yield huge returns if a market moves lower quickly. 

Since the chief determinant of option premium is volatility, when you buy an option you are making a bet that volatility will increase. When you sell an option, you are betting that volatility will decrease. Therefore, owning a ratio option spread where one sells fewer options than are bought amounts to a bet on volatility increasing. If it does, the options all increase in value but the rate of change on a percentage basis of the options owned tends to be greater than the option sold.

I remember doing a ratio call option spread in the silver market in 1987. A colleague and I sold one $6 call option when silver was trading at $5.75 per ounce. At the same time, we bought five times as many $8 call options and the premium for the trade was zero. The sale of the $6 call offset the purchase of a boatload of $8 call options. Silver went over $10 before expiration and we cleaned up! At $10 the loss on the short $6 call was $4 but the profit on the $8 call amounted to $2 times five or $10 per ounce. Each ounce of the spread resulted in a profit of $6. It was a risky trade that paid off; we had risk of $2 per ounce or $2 million per million ounces of spreads on this trade.

The futures market affords leverage for market participants; the options market can magnify leverage even more.

In the world of trading and investing the greater the rewards one seeks, the greater the risk they must shoulder. Ratio option spreads are a risky proposition but when they pay off the profits can be very juicy.