Keep in mind that while this trade does face unlimited risk, the risk is distant from the market price at the time of entry. This is in stark contrast to the risk faced by a futures trader. I have learned that you can never underestimate the markets, but the odds of a 142 point drop in the e-mini S&P in the next 60 days prior to option expiration, isn’t necessarily high.
Put Ratios for Risk Management
As mentioned above, this trade can be used as an insurance policy. I have been known to point clients toward a trade similar to this one as a means of providing a quasi-hedge against short put positions that are under pressure. At expiration, this spread insures a move below 2050.00 to 1980.00 tick for tick. As explained, below 1980.00 the trade gives back profits...thus the insurance policy begins to become less valuable. Below 1908, the trade that was intended to be a hedge short put options, now becomes a burden that results in even more losses. Therefore, when using ratio spread as a means of risk management you should be aware of major support and resistance levels and place the strike prices of the spread accordingly. You don’t want your “cheap” risk management technique to become an expensive lesson.
Disadvantage of Ratio Put Spreads
It is important to note that a ratio spread can sometimes involve unintended consequences at any point prior to expiration. At option expiration, there is no time value in the options and the profit and loss will be strictly dependent on the aforementioned calculations. Nevertheless, due to the time value still present in the option premium, it is possible for a spike in volatility to create a scenario in which the combined value of the short puts gain in value faster than that of the long put. In other words, it is possible for the market to move in the anticipated direction but create a loss to the trader. Assuming that the futures contract is trading above the reverse break even at expiration the losses will be only temporary; however it is never fun to be a part of an explosion in volatility which turns a good directional speculation into a losing trade.
Conclusion on Ratio Write Option Trading
Ratio spreads can be a powerful trading tool but proper construction and execution are key in producing favorable results. Poor timing in terms of volatility and price, along with incorrect strike price placement, might result in a very unpleasant trading experience.