Example of a Commodity Put Ratio Spread:
Perhaps one of the most opportune markets to employ a put ratio spread strategy in the futures market is in the stock indices. This is because of a concept known as the “volatility smile” which tends to keep the value of puts, particularly deep out-of-the-money puts, overvalued. This is because traders know equity markets tend to take the stairs up, but the elevator down. It is a market than can, and will, see precipitous declines from time to time; accordingly, speculators are willing to bid the price of puts higher to increase their odds of being at the right place at a the right time.
Compliments of the volatility smile, it is often possible to construct a put ratio spread strategy using the e-mini S&P futures options providing the trader with a relatively large profit zone at little cost, or maybe even a credit. For instance, with the e-mini S&P 500 futures price near 2185 it might have been possible to purchase a 2050 put with roughly 60 days to option expiration for 32.00 points, or $1,600. The dollar amount is determined by multiplying the premium by $50 (32.00 x $50 = $1,600).
Obviously paying $1,600 for a single option speculation is a rather expensive venture. A trader might opt to finance the purchase of the 2050 put with the sale of 2 1980 puts for 17.00 per option, or 34.00 points. We now know that the dollar value is figured by multiplying the premium by $50; accordingly, selling the 1980 puts would bring in a total premium of $1,700. This creates a credit of $100 to the trader. Simply put, the “market” is paying the trader $100 to participate.
A put ratio spread such as this one be used by the bears as a way to enter the market without the immediate risk that comes with the strategy of selling a futures contract. Put ratio spreads might also be used as a means of hedging existing bullish strategies, in this case it can often be looked at as cheap insurance. For example, a trader that is short a put outright faces unlimited risk, but adding a ratio spread beneath it can be a way to cheaply hedge some of the downside risk. However, this insurance policy has a deductible in the form of downside price risk should the market drop extremely sharply. Let us explain the mechanics by looking at the recommended trade in detail.
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