Setting Up the Advantage—Selecting Strikes

A ratio-spread involves selecting two different call option strikes in the same month of expiration. Selecting the lower strike first is pretty much an art form, and it’s more than a little dicey. In the best of all possible ratiospreads,
we’d love to see the market move up to or somewhat above the lower strike with just a week or two left until expiration. When this occurs (rarely), we will pocket a profit on both sides of the spread, which is always a lot of fun.

We do want to leave some small chance for this result to happen,while at the same time leaving only the most miniscule statistical possibility that the market will go as far as the upper strike until we’ve defended/adjusted our position satisfactorily. Clearly, the wider the price differential between the two strikes of our trade, the more relatively likely this double profit will be, although it won’t (or at least shouldn’t) ever be a statistically likely outcome when we enter the trade.

The rule here is safety first, then a dash of opportunism when and as available.The better way to select our strikes is to choose the upper strike first.Set it at the maximum distance away from the current market price, consistent with our goals for ROC. One good way to locate a promising upper strike is to set up a dummy account in the PC-SPAN program. Then, begin the selection process by examining the highest WTBOOM strike in the options price table for a particular month that has a net premium of $150–200 (or more, of course, as in the coffee example), typically expiring in 4 or 5 months.

Next, scan back down the table until reaching a strike having a net premium of 2 to 3 times the net premium of the upper strike option. We definitely must include commission cost when evaluating these strikes, for the calls that we’ll write in this strategy will not ordinarily have super-high dollar premiums, and the Martian ratio-spread is fairly highly commission intensive compared to other strategies.

Having gotten this far, let’s next check the SPAN initial requirement for a 1-to-4 trade using these two strikes, and multiply that number by 3. If the resultant notional return on capital meets precondition 7, this might be a good opportunity. There are still the other preconditions to check, and in any case the chance that our order(s) will be filled at tonight’s closing prices is virtually nil. If the notional ROC isn’t satisfactory, move the lower striking price up one notch and check the figures again.

If it still isn’t satisfactory, let’s run another analysis based on writing one more call, making the ratio 1-to-5, or adjust the ratio to 2-to-9. Sometimes, we can ratchet the ratio up to 1-to-6, but the option IVs must have fallen off rather sharply from their recent highs before we consider this ratio, as noted in precondition 3.Move the parameters around, check the spreads a month further out, use your imagination in order to find an optimum combination.

Typically, I’ll have to run through a dozen or fifteen combinations of strikes and ratios and months in the market I’m examining before either finding a disciplined pair of strikes or deciding this strategy isn’t suitable for this market at this time.Conditions 3 and 4, concerning option IVs, are a bit redundant. Martian ratio-spreads aren’t about picking tops, though, and we must insist on seeing at least the start of a decline in the market’s volatility, preferably

accompanied by some sort of modest downmove in the price, before using this strategy.The behavior of this market’s options’ IVs won’t follow a hard-andfast pattern. Sometimes IVs fall out of bed immediately when SV begins to decline, sometimes they stick around at lofty levels for awhile, sometimes they move down in tandem with IV as the

market declines. When the IVs are toward the high end of their 6-month range, we’ll probably be able to establish a good ratio-spread having a lower ratio; when they’re not (they’re still relatively high, regardless), we’ll likely have to employ a higher ratio or else pass on the trade.

No matter what ratio and which strikes we ultimately select, if the trade cannot be established at a very clear net credit and with ROC in line with orbetter than required by our precondition, forget about it. When we’re trading to win, the other trader’s dollars start off in our pocket, not ours in his, save in two distinct strategies discussed elsewhere in the text.Precondition 5 is unavoidable.

If you don’t favor trades with a term of three to six months, don’t use this strategy. As mentioned, I’ve never seen a 2-month term in a worthwhile Martian trade. Not to say such a trade can’t occur, but there are better ways to spend your time than looking for shorterterm Martian ratio-spreads, except in the markets having the very highest native volatility. Condition 6 is more vital in this strategy than in others.