Ratio Backspreads - Profit Even When You're Wrong
Ratio backspreads are considered to be one of the safest longer term option trading strategies available today. So much so, that they have sometimes been called "vacation spreads" because you can literally take a holiday and come back later to find they've made a profit for you.
The word "ratio" in the strategy gives us a clue to how you would structure ratio backspreads. There is a relationship, or ratio, between a combination of bought and sold positions which open the trade. Usually, it would be something like 2 to 3 - i.e. buy 3 and sell 2 - hence, the ratio.
In order to understand what we are about to say, it is assumed you are familiar with the meaning of the expressions "in the money" or "at the money" as it applies to options.
The idea is that you BUY a larger amount (e.g. 3) of "at the money" or slightly "in the money" options and simultaneously SELL a slightly smaller amount (e.g. 2) of "deeper in the money" options. The beauty of ratio backspreads is, that even if your view of the stock price direction is wrong, you can still make a profit. This is due to the fact that the "delta" component of all positions increases, the deeper the underlying stock price goes "into the money" until it reaches a point where all positions have equal delta. The delta is the relationship between the movement in the price of the underlying stock and its associated option.
So if you have taken out a put ratio backspread and the stock price declines, the 3 "bought" option positions will eventually increase in value at the same rate as the stock price movement - and because you have more "bought" than "sold" positions, you're making a profit. However, if the price action of the stock goes north instead of south, the "bought" positions will lose money, but so will your "sold" positions.
Because, when you opened the ratio backspreads trade, your 2 "sold" positions were "deeper in the money" than your 3 "bought" positions, you should've entered the trade with a net credit. You will get to keep this initial credit to your account and so, still make a profit, even if a smaller one than you hoped.
The other factor contributing to the above is the "implied volatility" (IV) of option prices. If we have taken out put ratio backspreads and the stock price takes a dive, this generally leads to an increased implied volatility for our 3 "bought" put option positions and consequently, will enhance the profitability of the trade, since we bought them "at the money" while the 2 "sold" positions were already "deep in the money". The best time to enter this type of trade is when the "at the money" options have a low implied volatility, while the "in the money" (sold) options have a higher IV.
Ways to Use Ratio Backspreads
Knowing the above, you can sometimes combine both call and put ratio backspreads for one simultaneous position. You should get a credit for each of the setups. If the stock moves north, your call ratio backspread makes a profit while your put ratio backspread realizes a small credit ... and vice versa if the price of the underlying stock moves south. In order to profitably enter such an an arrangement however, you need to take into account broker commissions, due to the large number of positions involved - and also ensure there are no volatility spikes for any of your option strike prices.
The ratio backspread is one of the more advanced option trading strategies, in that it allows a trader to have limited risk while realizing a nice profit if the underlying price moves in the anticipated direction. The bigger the move, the more profit you make, so you should look for stocks where you think the price will move significantly, such as the support or resistance of a channel pattern. As a general rule, the shorter time to expiry, the closer you would want your strike prices to be. Be sure to construct a risk graph before entering the trade so that you understand your risk vs reward.
Ratio spreads can also be constructed in a way that offers a huge reward for minimal risk. Click the next link to see a worked example of a put ratio spread in action, with a total cost of only $600 and a potential profit of $9400.