(Thread) Trading Ratio Spreads (Part 1)
Let’s try to understand what factors impact ratio spreads and how to trade & risk manage them.
As it’s impossible to fit everything into one thread I’m dividing this into two. I’ll cover factors that affect ratio spreads
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Let’s try to understand what factors impact ratio spreads and how to trade & risk manage them.
As it’s impossible to fit everything into one thread I’m dividing this into two. I’ll cover factors that affect ratio spreads
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in the first part and then discuss how to trade & risk manage them in the second (which I’ll post tomorrow morning). Finally, I’ll discuss the best case scenario to trade them that has a very good risk reward.
A quick (boring) intro:
Ratio spreads (RS): Short OTM/ATM options
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A quick (boring) intro:
Ratio spreads (RS): Short OTM/ATM options
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and go long options that are more in the money than the options shorted. Quantity of options shorted are in multiples of quantity of options bought.
Factors that affect ratio spreads:
(super important)
Delta wrt TTE – As we near expiry, delta of OTM option goes down(see pic)
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Factors that affect ratio spreads:
(super important)
Delta wrt TTE – As we near expiry, delta of OTM option goes down(see pic)
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(as price needs to approach payoff) and that of ITM options goes up. This factor is more important on Wednesday/Thursday.
Delta wrt IV – As IVs increase there is more “meat” in the option price profile and so delta of OTM options increase and that of ITM options decrease (pic)
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Delta wrt IV – As IVs increase there is more “meat” in the option price profile and so delta of OTM options increase and that of ITM options decrease (pic)
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This factor is more important on days other than Thursday when IV behavior isn’t that relevant except timing of entry.
Effect of IV & Skew –When IVs increase in a down move skew also increases (typical case). A put ratio spread is a short skew trade. Hence if index keeps
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Effect of IV & Skew –When IVs increase in a down move skew also increases (typical case). A put ratio spread is a short skew trade. Hence if index keeps
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moving down a PRS position will get hit badly. See pic below for PRS. This factor is more important on days other than Thursday.
Choosing a “range” for RS. Range is important as this determines how much breathing space one has got to add, adjust or defend the positions.
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Choosing a “range” for RS. Range is important as this determines how much breathing space one has got to add, adjust or defend the positions.
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We can define range covered by ratio spreads as interval from strike of long option to the breakeven level (in the payoff space). Pic below (all these pics are drawn by hand on Paint 3D so pls excuse any minor defects). Due to existence of vol skew, the range one gets by
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entering a put ratio spread at a certain cost is typically larger than what you get when entering a similar cost call ratio spread.
A larger range is also one of the reasons why I trade put ratio spreads more compared to call ratio spreads.
Before wrapping up this part,
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A larger range is also one of the reasons why I trade put ratio spreads more compared to call ratio spreads.
Before wrapping up this part,
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a note on the long option leg of a ratio spread. This serves as the best “indicator” of where your overall position is heading. If one trades a credit RS then, for starters, a loss in this leg is great(!) and we don’t have to monitor the short leg whatsoever unless we want
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to shift the RS to improve profits. Behavior of this option’s delta or its IV, gives a perfect health check on the overall position.
I’ll discuss trading ratio spreads in the second part tomorrow morning.
(END)
I’ll discuss trading ratio spreads in the second part tomorrow morning.
(END)
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