Spreading with an Attitude—The Ratio-Spread

A ratio-spread is a trade in which we purchase a call option and write some number of higher-strike call options against it. In a traditional ratio-spread,we buy an ATM or slightly OOM option, and we write two higher-strike OOM options of the same expiration against it, with the written options typically having too high an IV relative to the option we purchase. Or, we might buy five calls and write seven other calls against them.

Traditionally, we try to take advantage of an apparent skew in today’s option premiums, as compared to the computed fair values in our selected model.Ratio-spreading is a time-honored strategy and works very well under either of two conditions. If the skew in the option premiums is pronounced,we might well profit just from the correction of this skew over the passage of time. If the underlying market moves moderately higher during the life of the options, the trade will almost certainly end up profitably.

The traditional ratio-spreader obviously prefers to see both these conditions eventuate.From our unashamedly pragmatic standpoint, though, this strategy is a bit of a problem to execute.Option pricing skews in near-the-money options vanish very quickly as a rule. There are lots of institutions and traders who look for these opportunities on a more or less continuous basis, and who have the computing power to locate them efficiently and speedily.

You might have the time and computing power available (I don’t), but the chances are very good that investment banks and funds have just a trifle more of both of these than you do.We don’t need to play the game according to their rules. Additionally, this type of ratio-spread begins at a debit. While traditional ratio-spreaders are delighted when they can generate a credit from a (typical) 1-to-2 ratio-spread, they don’t mind a bit entering the trade with a debit.As is very clear by now, I do mind.

I flat won’t do that, except when buying straddles and in one strategy described in Chapter 12. Therefore, this strategy is off the table for me . . . or, at least this version of the strategy is.Here, we must gracefully part company with most of the folks who theorize and write about ratio-spreads, for we can do far, far better with our time and capital.When the volatility of a market, having risen sharply in previous days, weeks,or months, begins to decline, we can look around for ways to implement our version of the ratio-spread.

When the force or event(s) driving the volatility increase begins to subside, our mission becomes simple. If the rise in volatility was based on drought (coffee, October-November 1999), and it begins to rain in critical geographical areas, we’re in. If the rise was based on the condition of some nation’s economy, and this economy stops going in the tank (USD/MXN, the dollar versus the Mexican peso, early 1995), we’re in.

If the rise was based on political developments, and the feared politico-economic situation improves substantially (crude oil, January 1991), we’re in. So, what does our version of the ratio-spread look like?When I first showed my new methodology (new to me, anyway; someone undoubtedly has thought of this before) in ratio-spreading to a couple of other traders, one of them—gotcha, Don!—shook his head at me, rolled his eyes, and said “Man, that’s really from Mars. You’re gonna get killed with that.”

All right, if I’m a Martian then I’m a Martian, but obviously, he was somewhat incorrect in his evaluation. To paraphrase Mr. Twain, rumors of my death have been greatly exaggerated. Herewith, then, the Martian ratiospread strategy. This is the single most consistently profitable strategy I’ve ever run across. The usual ratio-spread trader is concerned with mispriced options ATM or moderately OOM, and he would prefer the market to be slightly bullish in its orientation.

We Martians are also concerned with mispriced options, but only with WOOM- and WTBOOM-strike calls, and the farther OOM from the current market price the better. Occasionally we can locate absolutely excellent opportunities to exploit overpriced calls and the underlying IV situation by using these strikes.The delightfully useful fact of the matter is, that, when call premiums get bid to very high levels, they tend to stay there for a while and the IVs of these options tend to decline fairly slowly over time.

Some markets have taken a year and more before the premiums of its WOOM and WTBOOM calls have returned to historically typical levels. We might apply a nonseasonal trade in these situations, assuming our preconditions were fully met, but if we do take the simple non-seasonal trade when call option volatilities are way high, we might end up accepting more risk than we should.Let’s not do that.