One of the primary benefits of trading options is the ability afforded to a trader to craft a position with specific reward/risk characteristics that are not available to the trader who deals only in the underlying stock or futures contract.
What this means is that the buyer of 100 shares of stock will make or lose $100 every time the stock rises or falls $1 in price. An options trader, however, is not limited to this straightforward equation; he or she can enter a position that will make money if the underlying security goes up a lot, goes up a little, stays in a particular range, goes down a little, and so on and so forth. The key to success is to understand the actual reward-to-risk characteristics for a given strategy and apply the appropriate strategy at the appropriate time. (To learn more on how options can be used to customize your trade, check out our Options Basics Tutorial.)
One strategy that offers a unique reward-to-risk profile is known as the "long ratio backspread." This strategy is quite different from many other option trading strategies. Most traders new to options focus on writing covered calls - which limits profit potential and offsets only a small portion of downside risk - or buying calls and puts - which offer unlimited profit potential but which also run the risk of a complete loss of the premium paid if the underlying security fails to move in the anticipated direction. (Check out our related article Backspreads: Good News For Breakout Traders to learn more about backspreads and their uses.)
A long ratio backspread allows a bullish trader to enjoy unlimited upside profit potential as well as the opportunity to make a profit if the underlying security declines in price. Likewise, a trader who is bearish can enjoy unlimited profit potential if the security declines in price, as well as the opportunity to make a small profit if the underlying security rises in price. As with any strategy, there is no free lunch. Whether using call or put options, this strategy can lose money if the underlying security remains in a trading range until option expiration.
Definition of a Long Ratio Backspread
A long ratio backspread (for the sake of simplicity, heretofore referred to simply as a "backspread") can use either call or put options, depending on whether you primarily expect the underlying security to rise or fall in price.
To enter a backspread using call options a trader would:
- Sell a call option with a lower strike price and;
- Simultaneously buy a greater number of call options with a higher strike price.
Most typically this is done in a ratio of 1:02 or 2:3. In other words, a trader who is bullish on a particular stock might sell one call option with a strike price of 20 and buy two call options with a strike price of 25. This is known as a call ratio backspread. On the other end of the spectrum, a trader who is bearish on a given stock might sell two put options with a strike price of 55 and buy three put options with a strike price of 50. This is known as a put ratio backspread. Together, they are both known as long ratio backspreads because the long component of each is larger than the short components.
To better illustrate this concept, let's look at an example. In Figure 1, you see a bar chart for the stock of Celgene (Nasdaq:CELG). As you can see in the bar chart, CELG had recently formed a double top and the 10-day moving average had dropped below the 30-day moving average. This combination of factors might prompt some traders to look for a move to the downside. (Read the Moving Averages section of our Technical Analysis Tutorial to learn more about this signal.)
|Figure 1: Celgene Stock "rolling over" from a double top|
Reward versus Risk
One possibility for a risk-averse trader looking to play the downside with CELG would be to enter into a put backspread by selling one put with a strike price of 80 at a price of $12.40 a contract, and to simultaneously buy two put options with a strike price of 70 at a price of $6 a contract. The options in this example have 142 days left until they expire. In this example, the trader sells one 80 strike price put option worth $1,240 and buys two 70 strike price put options worth a total of $1,200 (two contract x $6 a contract x 100 shares) and thus takes in a credit of $40 when entering the trade. Figure 2 displays the resultant risk curves for this trade.
|Figure 2: Risk curves for CELG put ratio backspread option position|
|Source: Optionetics Platinum|
As you can see in Figure 2, if CELG declines in price, this trade enjoys unlimited profit potential. On the flip side, if the stock rises, a trader could hold this position and ultimately keep the initial credit of $40 if the stock was above $80 a share at the time of option expiration. The major risk associated with this trade would only be realized if the trade was held until expiration and the stock closed at exactly $70 a share.
The risk curves illustrate the concept of time decay. Option prices have a certain amount of "time premium" built into them. The time premium built into the price of each option essentially serves as an inducement for someone to assume the risk of writing a particular option. All time premium evaporates by the time an option expires. This process accelerates rapidly in the last 30 days prior to expiration. This phenomenon can be viewed in Chart 2. You will notice that during the early stages of the trade it is almost impossible to lose a lot of money. It is not until expiration approaches that the risk curve breaks sharply to the negative side. (To learn more about time premium and its decay, read The Importance Of Time Value.)
This is one of the most attractive features of a long ratio backspread. A trade can be entered and held for a significant period of time without the risk of a large loss. If a trader resolves to exit a backspread prior to expiration he or she can never experience the maximum potential risk associated with the trade.
The Bottom Line
Many beginners focus on buying calls or puts in an effort to leverage a market timing opinion. And while the potential rewards are great, the fact remains that no one bats 1,000. If you trade enough there will be times when the underlying security will do exactly the opposite to what you expect. A long ratio backspread can offer you a number of advantages versus buying or selling short stock, and/or buying call or put options. Individuals who truly seek the best opportunities might do well to learn more about this unique option trading strategy.
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