Options trading time and again shows us how convenient it is to accentuate the benefit of a favourable situation or many times how convenient it is to minimise the impact of an unfavourable situation.
One such window of opportunity in Options trading is presented by trading Option combinations comprising of ‘ratios’.
Ratios are not so widely used and discussed as it requires execution of three trades to take a position in one underlying.
Still, they have a specific time and place where nothing else would work as effectively as ‘Ratios’. We will understand what are these ratios and the correct time and place to get the most convenience out of them responsibly.
Typically, a Call Ratio Spread would involve buying a Call Option with a strike close to the current market price and selling two Call Options at least two strikes higher.
Similarly, a Put Ratio spread would involve buying a Put strike near the current market price and selling two Put options at least two strikes lower.
The obvious threat here is the additional selling which is done. It brings in a threat of losing out on super performance in our favour due to the additional option sold.
In the last 5-7 sessions ahead of expiry, when the time value decay is at its highest, that is where a single option bought might actually be outdone in terms of stock price sensitivity by the time value decay.
Here we should deploy Ratios starting from last Friday of expiry. It is quite possible, even if it takes a couple of sessions, that a two-strike apart ratio would let one reap the profits when the stock reaches the sold strike.Convenience:
This trade would give a lot of advantage against the peril of Time Value Decay. The stop-loss would be minuscule and given time it would outperform a single Call.
Responsibility: The exit strategy should be tightly executed especially the booking of profits or it could turn ugly.2. Back Ratio Spreads:
The situation requires us to have movement of large proportions in a few days. The issue with these movements in a single Option with fat premium is that it would impose a large loss, while the Back Ratio would have a compounding impact of two Options outdoing one.Short OptionBest execution of this trade is when we have some sort of event-led excitement expected in the underlying in the beginning of expiry.
Convenience: If there is a big move in our favour, we make money. If things do not work out and no matter how lethal the unfavourable move is, either the losses are super small or at times there could be a profit from a huge unfavourable move.
Responsibility: With two Options long, we are heavily negative on time value decay impact, so we need to make sure we execute the trade with at least three weeks to expiry and get rid of the trade within five days of execution.
Thus, ratios can help us get over the peculiar pain points while trading Options with a responsible deployment in the aforementioned use cases.
(The author is CEO & Head of Research at Quantsapp Private Limited.)Disclaimer: The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.