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Ratio Backspread - Definition
Credit volatile options trading strategy that opens up one leg for unlimited profit through selling a smaller amount of in the money
options against the purchase of at the money or out of the money options of the same type.
Ratio Backspread - Introduction
As the same suggests, Ratio Backspreads are backspreads, which means that they are options trading strategies designed to profit no matter if a stock goes upwards
or downwards strongly.
Such volatile conditions might be expected ahead of important news
releases, court rulings, rate decisions and any conditions that might cause uncertainty as to the future direction of the market or stock.
Ratio Backspreads allow options traders to take both
bullish and
bearish stance simultaneously in order to
profit no matter which way the underlying stock moves.
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How are Ratio Backspreads Different from Regular Backspreads?
First of all, Ratio Backspreads are exactly like the regular
backspreads in the sense that both are designed to profit when the underlying stock
goes up or down strongly. The difference between Ratio Backspreads is that ratio backspreads has the advantage of being the only
credit backspreads
that are capable of unlimited options trading profit in a single direction! No regular credit backspreads are capable of unlimited profits either way. Lets look
at the
risk graph of a Ratio Backspread (
call ratio backspread) and a regular credit backspread (
Short Butterfly Spread) below:
As you can see above, the Short Butterfly Spread has limited profit no matter if the stock goes up or down but the Call Ratio Backspread has
unlimited profit if the stock went upwards and a limited profit if the stock went downwards. This is the main difference between Ratio Backspreads
and regular credit backspreads. In fact, ratio backspreads are backspreads with a directional bias. This directional bias is what sets ratio
backspreads apart from the regular backspreads. Ratio backspreads are truly examples of the extreme flexibility and versatility that you can only get through options trading.
When will you use Ratio Backspreads
You should use Ratio Backspreads when you are of the opinion that a stock might
breakout strongly to topside or downside and that
there is a higher chance it will break out in a certain direction and continue in that direction.
For instance, if you are of the opinion that AAPL would stage a
breakout soon and the breakout would probably be to upside. You want to have unlimited profit to ride the upside profits should that happen
but you also want to make a limited profit if AAPL should break out to downside instead. In this case, you would use a Call Ratio Backspread.
Ratio Backspread Strategies
Here is a list of Ratio Backspreads:
Call Ratio Backspread -
Ratio backspread using
call options only with unlimited profit to upside. It involves buying more
at the money call options than
in the money call options
are shorted.
Put Ratio Backspread -
Ratio backspread using
put options only with unlimited profit to downside. It involves buying more at the money put options than in the money
put options are shorted.
Call Diagonal Ratio Backspread -
Similar to the Call Ratio Backspread except that long term call options are bought and nearer term call options are shorted. This allows the
stock more time to breakout. It is also classified as a form of
Diagonal Ratio Spread.
Put Diagonal Ratio Backspread -
Similar to the Put Ratio Backspread except that long term put options are bought and nearer term put options are shorted. This also allows the
stock more time to breakout. It is also classified as a form of
Diagonal Ratio Spread.
Advantages of Ratio Backspreads
Ratio backspreads are all
credit spreads, which means that you receive money for putting on the position, money which can be reinvested elsewhere
during the life of the position. More than being just credit spreads, Ratio Backspreads are the only credit backspreads with a directional bias
where one leg is opened for unlimited profits. This makes ratio backspreads perfect for speculating on a breakout that isn't just 50/50.
Drawbacks of Ratio Backspreads
Even though Ratio Backspreads offers the unique ability of profiting from both up and down moves, its nemesis comes in the form of stock remaining stagnant.
As Ratio Backspreads are typically put on ahead or during periods of high volatility resulting in high option premiums, potential losses should the
underlying stock remain stagnant could be very significant due to
time decay and ditch in
implied volatility, what we call a volatility crunch in options trading. Even though stocks rarely stay stagnant over significant periods of time, Murphy's
Law does apply and Ratio Backspreaders need to be aware and cater for such potential options trading losses. Fortunately, maximum potential losses can be precisely
calculated for all Ratio Backspreads. As such, you would be able to determine in advance if the potential reward justifies the risk involved.
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