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Risk Graphs: Put Ratio Spread
October 31st, 2009 | 
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-The Put Ratio is nothing more than a Bear Put with an extra Short Put usually at the strike price of the Short Put in the Bear Put. Example: BTO one Long Put at 25 and STO two Puts at strike 20. The maximum reward is achieved if the stock settles at the Short Put strike. The trade can be placed for a debit or a credit. If the stock settles between the long and short strikes, we will achieve profit but it is reduced and the downside break even is the Long Put strike less the debit (if placed for a debit). If placed for a credit, the trade will make a small profit wherever it settles above the Long Put Strike.
The downside profit begins to diminish the further the stock falls below the Short Put strike. The Short Puts will cost more to close as the stock falls which is detrimental to the seller of the Puts, so even though the 25 Long Put is increasing in value, the Short Puts are losing faster that the Long Put is gaining. At expiration, when the Stock falls below the amount of the Short Put premium collected, the position begins to lose. Because there is one Put uncovered, the trader must post margin on the trade.
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Risk Graphs: Short Guts
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Sell an ITM Call and an ITM Put usually equidistant from price. The trade is done for a credit. In order to be profitable the trader needs the stock to remain stagnant and between the short options. The maximum reward is the credit and the maximum risk is unlimited to the upside and to zero on the downside. The breakevens are the Short Call strike less the credit to the downside and the Short Put strike price plus the credit to the upside. Review the risk graph and you should gain understanding of the risk and reward of the trade. Best, Robin
Risk Graphs: Call Ratio Spread
-The Call Ratio is nothing more than a Bull Call with an extra Short Call usually at the strike price of the Short Call in the Bull Call. Example: BTO one Long Call at 25 and STO two Calls at 30. The maximum reward is achieved if the stock settles at the short call strike. The trade can be place at a debit or a credit. If the stock settles between the long and short strikes, the profit is reduced and the break even is the Long Call strike plus the debit (if placed for a debit). If place for a credit, the trade will make a small profit wherever it settles below the upside breakeven.
The upside profit begins to diminish the further the stock rises above the Short Call strike. The Short Calls will cost more to close as the stock rises which is detrimental to the seller of the calls, so even though the 25 Long Call is increasing in value, the Short Calls are losing faster that the Long Call is gaining. At expiration, when the Stock rises beyond the amount of the Short Call premium collected, the position begins to lose. Because there is one call uncovered, the trader must post margin on the trade.
Risk Graphs: Put Ratio Backspread
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The Put Ratio Backspread is configured with the Short Put either ITM, ATM or slightly OTM. It is suggested that the Short Put be placed ATM in order to capture the most extrinsic value. Ratio Long Puts are purchased ususally one strike below the short puts at a ratio of two or three to one.
The strategy is implemented with the expectation of an explosive move to the downside. The Short Put helps finance the Long Puts. The trade can be put on for a debit or a credit. The trade in our example is placed at a credit. The Short Put totally finances the Long Puts with an additional amount to create a credit. The maximum risk is the difference between the Long and Short strikes less the credit or plus the debit as the case may be. The reward is the credit (if placed for a credit) if above the Short Put strike or unlimited reward as the stock moves below the Long Put. The maximum loss is incurred if the stock finishes at the Long Put strike. In the example, that would be 30.
This strategy could be considered when one expects a big move around a catalyst like earning. Obviously, the strategy is bearish to extremely bearish, so even though the trade can be profitable if it goes bullish in the amount of the credit received, it is best if the stock is massively bearish. This trade can be used instead of a straddle of strangle if one has a bearish bias knowing that if the direction is not right, money can still be made to the upside.
Review the risk graph to gain better understanding of the risk and reward of the position. Best, Robin
Risk Graphs: Call Ratio Backspread
-The Call Ratio Backspread is configured with the Short Call either ITM, ATM or slightly OTM. It is suggested that the Short Call be placed ATM in order to capture the most extinsic value. Ratio Long Calls are purchased usually one strike above the Short Calls at a ratio of two or three to one.
The strategy is implemented with the expectation of an explosive move to the upside. The Short Call helps finance the Long Calls. The trade can be put on for a debit or a credit. The trade in our example is placed at a credit. The Short Call totally finances the Long Calls with an additional amount to create a credit. The maximum risk is the difference between the Long and Short strikes less the credit or plus the debit as the case may be. The reward is the credit (if placed for a credit) if below the Short Call strike or unlimited reward as the stock moves above the Long Call. The maximum loss is incurred if the stock finishes at the Long Call strike. In this example, that would be 40.
This strategy could be considered when one expects a big move around a catalyst like earnings. Obviously, the strategy is bullish to extremely bullish, so even though the trade can be profitable if it goes bearish to the tune of the credit received, it is best if the stock is massively bullish. This trade can be used instead of a straddle or strangle if one has a bullish bias knowing that if the direction is not right, money can still be made to the downside.
Review the risk graph to gain better understanding of the risk and reward of the position. Best, Robin
Double Diagonal
-The Double Diagonal is a non-directional four option trade that can be set up as either a credit or debit spread. It is preferred to set it up for either a SMALL debit or a SMALL credit. It may be tempting to seek out a trade with high front month volatility, but it is suggested to avoid such situations because high IV may be indicative of a large impending move which can be adverse to the Double Diagonal. The risk in the trade is the difference in the spread between the short and long option less the credit or plus the debit as the case may be. The reward can be hard to determine because volatility will impact the resulting profit. Ideally, you want to enter the trade at a point of low volatility with an expectation of increasing volatility.
The trade is similar to an Iron Condor in that we sell out both Puts and Calls usually in the front month and we have protective outside strike long Put and Call options. The difference is that the long options are in the back month. So instead of two verical credit spreads as is incorporated in the Iron Condor, we have two diagonal spreads thus, Double Diagonal.
The roll to the back month is when the most money is made in the position. If the stock remains fairly stagnant we can then buy back the decayed front month short put and call and roll to the same strike in the same month as the original long options. The resulting position is now an Iron Condor. If the stock does remain stagnant into the roll, we should end up with a very attractive risk reward on the Iron Condor.
Study the risk graph and you should gain understanding of the risk and reward of the position.
Risk Graphs: OTM Put Diagonal
This trade is set up as a credit spread just as last week’s example of the OTM Call Diagonal. The Short Put is placed in the front month near the money and the Long Put in the next month one to two strikes below the Short Put. It is a diagonal because it is a two legged position in different months and different strikes. The trade will profit anywhere above the breakeven of the near month Short Put plus the credit from the spread and possible Long Put appreciation.
The trade begins to lose rapidly as the underlying moves below the Short Put strike price. Volatility crush on the back month Put can also reduce the breakeven point below the Short Put strike price, so it is best to pay attention to the implied volatility of the Long Put when implementing the trade. The fact that the Long Put is further OTM should mitigate some of that risk because Vega is less. Review the risk graph and you should gain understanding of the risk and reward associated with this trade. Best, Robin
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