Welcome to the Fifth and final lesson from our
HOW TO PROFIT FROM COMMODITY OPTION TRADING course.Today we are going to discuss the RATIO OPTION SPREAD STRATEGY.
RATIO OPTION SPREAD:
A ratio spread is initiated by purchasing a close-to-the-money option and selling two or more farther out-of-the-money options; for example, with July soybeans trading at $8, we may decide to purchase a July soybean $9 call and sell two $12 calls. Let’s assume that the $9 call is trading at a premium of 20 cents ($1,000) and the $12 call at a premium of 12 cents ($600). We would then pay 20 cents for the $9 call ($.20 x $50 per penny = $1,000); and receive two times 12 cents or 24 cents for the $12 calls we sell ($.24 x $50 = $1,200). In this case, since we receive $200 more than we paid out, we are doing the spread at a credit of 4 cents or $200.
Receiving this credit is very important when doing the ratio spread, and beneficial for the following reasons:
1. First, if the market goes up as we expect in this example, we will receive a profit of $50 for every penny soybeans move over $9 at expiration (up to $12) for a maximum profit potential of $15,000.
2. Unlike a normal option purchase, there is no cost for your initial option purchase because it was paid for by the sale of the $12 calls.
3. In making this trade, we are also taking advantage of premium disparity in option premiums between strike prices. We find in most markets, particularly in grains and metals, that options that are closer-to-the-money have lower volatility (premium cost) than farther out-of-the-money options.
These out-of-the-money options have no intrinsic value because they have only what is known as “time value premium” This is a specific amount people will pay for an option because it has a chance of becoming valuable some time in the future.
We find that this time value premium decreases the farther out-of-the-money; however, there seems to be more demand by smaller traders to purchase “cheap” options. This can greatly increase the time value of these out-of-the-money options to a point where they, at times, are much more expensive than one might expect. Because the options are so far out-of-the-money, it is very unlikely the options will go into-the-money, yet the premiums do not reflect this lack of probability. Thus, they are, relative to the probability of profit, much more expensive than the close-to-the-money options. By using the ratio spread we can take advantage of this disparity in premium since it allows us to purchase the most reasonably priced close-to-the-money option and sell the relatively more expensive options that are farther out-of-the-money.
4. The farther out-of-the-money options we sell will also lose there time value faster as they approach expiration. Time value decreases for both an option at-the-money and out-of-the-money as it approaches expiration. This decline in time value is much more dramatic for the out-of-the-money option.
5. Finally, one of the biggest benefits of the ratio spread is the fact that, if the market does not move as expected, as long as we gain a credit when the spread is initiated, we will not have a loss. In my soybean sample above, let’s assume that soybeans are plentiful and the price of soybeans drops to $4. In that case, the options we purchased and sold will all be worthless at expiration. At that time, the net difference to our account from taking this position will be the 4 cent net premium we collected when we initiated this position; therefore, our account will increase by $200, even though the market moved against us.
There is only one situation where this position can run into trouble and that is, if the futures price exceeds the strike price of the options sold. To help control the potential for large losses under these conditions, we follow a rule that requires us to close out our ratio spread if the futures price exceeds the strike price of our short options.
The best time to initiate a ratio spread is when the market has made a quick straight up move. This is because this type of action normally increases the demand for out-of-the-money “cheap” options for the reasons mentioned above. This also seems to be when there is great disparity in premiums between the close-to-the-money and out-of-the-money options, providing the best opportunity for the ratio spread. I feel that the benefits of the ratio spread far outweigh the single problem area, that of the market rising too quickly, too soon. Also, these problems are easily handled by our contingency plan and the rules I described above. The ability to initiate a spread that can be profitable over a wide range of prices and market conditions allows us to have both financial and emotional security in the markets.
Trader Friend, This is the final lesson from our introductory option trading course. I have supplied you with some basic truths about trading and simple strategies to take advantage of the different situations.
These same strategies are fully explained using actual chart examples of trades in my LOW-RISK OPTION COURSE. And you will also learn how to trade seasonal price patterns that occur year after year further increasing your chances of success.
The OPTION ALERTS BY EMAIL AND PRIVATE WEB SITE service provided with the course are a fantastic way to really see how these strategies perform in real-time market conditions. I put my neck on the line each week to prove that they really do work and make you money by spotting trading opportunities for you and apply the simple strategies!
Here’s what one course member had to say:
Hi Arch,
Great options course! I’m learning so much more by seeing real life examples as they happen. This course is better than any other options course that I seen or taken (and I’ve both looked at and taken many).
I would like to add that while taking this course, it’s like I’m right there looking over your shoulder while you’re trading options. And when looking over your shoulder, I get to ask you questions and get answers from you that really lead to an in-depth understanding of trading options. Not many traders put themselves on-the-line by teaching trading with real time trades. That alone shows me that you’re the real deal.
Thanks again, John Sukosky
My 100% money back guarantee is simple. Buy the course, try it out and follow along as I trade in the Option Alerts, and if you don’t see the potential of making more profits than you expected, simply tell me so and I’ll refund every penny you paid!
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Take care, and I wish you the best in your trading business.
Archie Johnson
Virtual Trading University
Where Successful Options Trading Begins
Disclaimer - I am not a commodity trading advisor. The information on this site is for trading education only. There are no trading recommendations for any one individual made on this site and this information is paper trades for trading education. All trades are extemely risky and only risk capital should be used when trading.
U.S. Government Required Disclaimer - Commodity Futures Trading Commission Futures and Options trading has large potential rewards, but also large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the futures and options markets. Don't trade with money you can't afford to lose. This is neither a solicitation nor an offer to Buy/Sell futures or options. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed on this web site. The past performance of any trading system or methodology is not necessarily indicative of future results.
CFTC RULE 4.41 - HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSE SHOWN.