Liz: Hi everybody, welcome back to the Liz and Jenny show. I'm Liz, this is Jenny. This is our "Know Your Options" segment where we're talking about ratio spreads.
Jenny: We're talking about ratio spreads, and then we'll talk about the other thing during Trade Small, Trade Off.
Liz: Oh! I want to tell everybody we're opening up the phone lines right after the segment. 855-238-2789 or 855-Be-Tasty.
Jenny: Okay, so, Know Your Options. This is the segment where we talk about ratio spreads. We've gotten lots of emails about ratio spreads. Like I said, I love the email that said, "If you do an upside ratio spread and a downside ratio spread, and it doesn't cost you anything to put those on, how could you lose?"
Liz: Well, one would think. But there is definite risk in a ratio spread. You have a naked option. A ratio spread. Let's talk about what it is and how we use it. We are always buying one and selling two. Never the opposite.
Jenny: Buying one, selling two. Buying one of the more expensive, selling two of the cheaper. Ratio spreads will always … Wherever your break even is, and I think that people may not understand this. Wherever your break even is on a ratio spread, you look at the same naked option that would give you the same break even. You're going to collect the same amount that the ratio spread is going to give you.
Liz: There is some more, and I think it's interesting. You have to know what you're doing when you put it on, because they almost have the same risk. It just shows that there really is zero in the gaming system.
Jenny: It's just like selling … If you're doing a ratio spread, you're using different strikes, but it's the same thing as going out and selling a strangle. You have those naked options. The only difference is, you have that kicker if it ends up right at your short strike. You could make a little bit more. The difference is that you're doing way more contracts than just the naked options. It's easier to get in and out of the naked options. The ratio spreads, you almost have to wait til the end of the day, depending on how wide the ratio spread is, to get a good profit out of them.
Liz: Almost always. Depending on my experience …
Jenny: Depends on how wide. If you're doing a really wide, you see the shadow traders, they do these really wide ratio spreads.
Liz: For a collection.
Jenny: Or maybe they're paying a really small amount for it. But when you're doing a $20 wide ratio spread, that's different than if you're doing a $2 wide ratio spread.
Liz: Right. We're going to pull it up and we'll talk through the examples, and then we're going to talk through the risks and the parameters behind it. We're going to use Target, because they do have earnings. Either tonight, or tomorrow morning. I'm not exactly sure, I'll double check that. But because of that inflated high volatility, you want high volatility in a very shorter time. Personally, a shorter time frame. Because like Jenny said, you got to nail the strike. The longer the time frame, I don't typically do ratio spreads for duration trades.
Jenny: Well, we have a ratio spread, we have an upside ratio spread we did in BABA.
Liz: We have an upside broken wing butterfly we did in BABA.
Jenny: Okay, a broken wing butterfly ratio spread, it'd be looking the same. When it was up near our short strike, it was a loser because we needed time to come out of it. Whether we had an upside ratio spread or broken wing butterfly that would be a loser until time came out, because it's a December position. Now, it's down away from our strikes, it's a winner. Its net would be very similar, but it's a very small winner. If you take into credit, that credit is the most you can make if it goes in the opposite direction. You needed to end up by your short strikes, closer to expiration.
Liz: Right. Given the nature of the strikes, in my personal opinion, I don't put in any durational ratio spreads. I'm very notorious for putting in upside, or downside, broken wing butterflies for durational trades. But personally, I don't really put in durational ratio spreads in my own account.
Jenny: Well, and it's the same thing, and again I think it depends on the width of the spread.
Liz: Right, but typically with the broken wing butterflies, they're in higher price products. There's something with the duration, I'm always going to try and break the wing. That's just my personal trading style.
Jenny: It depends on how much capital. You know, those ratio spreads and some of the high price products look pretty appealing.
Liz: Oh, yeah! But so do the naked options in those high prices. It's the same thing that you're selling. If you're not going to go out and sell a naked column price line, don't do a ratio spread.
Jenny: Exactly. So if you wouldn't sell a naked option, if you wouldn't sell a naked call, don't do an upside call ratio spread. If you wouldn't sell a naked put, then you wouldn't sell a downside put ratio spread.
Liz: Exactly. If you don't want a close naked option because of the strike selection, don't do a ratio spread, break the wing. But, we're talking about ratio spreads today. Most of the time in my account, ratio spreads are for earnings.
Jenny: Let's go to the platform. Here we have Target, they do have earnings coming out. It's trading 66/76 with about a 250 expected move. We're going to put our short strike right at the expected move.
Liz: When we talk about these, we want the product to nail, or pin, our short strikes. That's why we're going to pick our short strikes first.
Jenny: So, let's go to the downside first. We'll put in the downside. If we go about $2.50 down, it brings us to 64.50. So if we sell …
Liz: Just sell the 64's.
Jenny: You can do the math really easily by looking at the options. If you know you're selling two and buying one. So if we sell two of these 64's and collect about 86 cents, then you could look and see "Well, what can I buy? Can I buy something less than that? How wide is my ratio spread going to be?"
Liz: For somebody who's been trading for a while, when you open up and option chain and see the options are pricing very similarly together, ratio spreads are possible. If you open this up, this is going to jump from 30 to 70 cents here, you know you're not going to be able to double a price and collect some.
Jenny: Let's say on the downside, we do two of these 64's. We'll do two 64's, and we know that mid market will get about 80 something cents. Then we can go up and buy the 65.5.
Liz: There's a $1.50. So 64 to 65.5 is a $1.50 spread.
Jenny: And taking the 7 cent credit.
Liz: Per the email you were saying here, if you're putting this on for a credit, you're buying one and selling two for a credit. Can you lose here?
Jenny: Yes, and I even think he meant in the email that he meant closer to … If you're setting up right at the money. So say you're setting up right at the money, where you're longs are right at the money. If it goes up or down, one way or another, you have that ratio spread down and up. Where you lose is beyond your break evens. You have that risk of the naked option. If you look at this, so taking in a 7 cent credit, our break even is 62.43.
Liz: So, people when they look at ratio spreads, that's why I like to understand what we're doing when we put it on. You've got a $1.50 spread in there, so there's $1.50 that you get to ad on to your short strike.
Jenny: Right. So we have that little 7 cent credit. How does our break even get all the way down to 64.43? Well we've got our short strike at 54, minus that 7 cent credit, minus the $1.50 spread that's in there. Because we've got that long spread in there.
Liz: Everything one for one underneath us, is technically a naked option. So we have a 7 cent collection, and our break even is 62.43. Why don't you show what the naked option is.
Jenny: Right. Here's the thing. If this ratio spread is giving us this credit of 7 cents, and I see a break even at 62.43, that tells me that 62.5 put is probably around a dime.
Liz: Right.
Jenny: Let's see if it is.
Liz: Well, right wrapped around there.
Jenny: With earnings, it might be a little bit inflated, but it should be pretty accurate. Usually, it should be about the same. Where that break even on a ratio spread, or that naked option, is a little bit higher. We've got that put skew and we've got the earnings announcement. So it's 20 cents. So if you sold that 62.5 put, you're getting 20 cents. Not too far off from the small credit on the return price.
Liz: No, that's right about there. That's exactly where it kind of should be.
Jenny: The same thing, it's that risk. So where's your risk on that ratio spread? Same type of risk as if you sold that put.
Liz: Right. The difference between … and why you do a ratio spread verses just selling that put. The price on that put, we want it to go up. If I do the ratio spread, I want it to go down. In this particular example, I want Target to hit, not through my short strike, I want it to go to.
Jenny: I want to just see, if you did it right at the money, how wide you can get it. You know, if you're buying the 66.5 put, the wider you can make these ratio spreads the better. If you're buying at the money, you're paying $1.17, so how far down can you go to cover that $1.17?
Liz: 65. You need 60 cents.
Jenny: 65. So same thing. That would be another $1.50 wide. Your break even is going to be much higher.
Liz: You've got to realize where your short strike is. Your short strike is 65, which is only $1.80 down from here. So, it's expected move would be through your ratio spread.
Jenny: 63.41
Liz: Is your break even, but you make the money when it hits it's short strike of 65, which is only $1.85 underneath it. Which is under the expected move.
Jenny: Right, so we would prefer earnings to me more conservative, whether we're still getting that $1.50 in spread. Maybe we won't get the full $1.50 on the spread, but we've got a chance, our break even is better.
Liz: Right. Exactly.
Jenny: But, now we're going to look at both sides.
Liz: That's the put side.
Jenny: Now, the cause. It might be different strikes, it might be different spread width.
I'm going to throw in the puts right now.
Liz: Yeah, separate it. Good idea.
Jenny: If we put this in as one package, there's just too many options.
Liz: Sometimes you get filled, but you're better off … we'll break apart the ratio spread.
Yeah, to the call spread and the put spread.
Jenny: So here's the downside put spread. Selling at 64 put, selling two of those, and buying one 65.5 put. That gives us that $1.50 wide debit spread.
You see, we have that long 65.5 put, short 64. That's that $1.50 debit spread. We sold an extra put to cover the cost of that, otherwise we would be paying for that debit spread.
Liz: Otherwise you're paying for that debit spread, that's excellent.
Jenny: If you don't want the risk of the naked put, know that buying a 64/65.5 debit spread is the same thing. Because if you pay for it, and it doesn't go down, then we're out and we don't want that.
Liz: I wouldn't put that on because it's got to move in my direction, just to make money.
Jenny: Right.
Liz: In this particular example, with just this put ratio spread, I collected 6 cents. I want Target to go directly to my short strike, to the 64. If Target declares earnings and it goes up to 70, it doesn't matter. I’ve lost nothing. My options are then out of the money and I've collected 6 cents. I don't have to trade out of them.
Jenny: Right. This is going to tie up about $1000. When we do the other side, it won't tie up any more.
Liz: Right, because you have both sides. You can't lose on both sides.
Jenny: This is only a three day play. This is going to expire at the end of the week and we may have to wait til the end of the week to get out of this with a decent profit.
Liz: Right, absolutely.
Jenny: So then we're going to look at the call side. Let's move on to the calls.
Hopefully we'll get filled. We don't trade Target too often.
Liz: We're going to leave this in though, Target's pretty liquid.
Jenny: Okay, if we go 250 up from about 65, 66.5. We go about 250 up, that brings up to the 68 strike.
Liz: Okay, perfect.
Jenny: No, we're higher.
Liz: About 45 cents exactly.
Jenny: Sames as about the puts.
Liz: We're going to sell two of those. So now we know we've got 90, 95 cent-ish.
So what are we going to buy?
Let's, you know we collected 6 cents, do you want to try to buy this?
Jenny: Right. What Liz is talking about here, if we made it $1.50 wide, up to the 67.5, we might have to pay a little bit.
Liz: And we know that because of the pricing of the options.
Here, don't let the negative … you're still paying $3 for this.
Jenny: We're paying $3 for this but we collected $6 on the other, so that's going to wash each other out. Now look at our break even on the upside, it's going to be 70.47.
Liz: It shows two because we paid a little bit for this.
I mean, honestly, because of the way we collected on the one and we're paying on the other, this is 70/47.
Jenny: If it doesn't go up to 67.63 on this side, we'd be out that $3.
Liz: We would be out that $3, that is correct.
Jenny: That's why. I don't want people to get confused about why they show both break evens.
70/47. We've got our downside break even, and I can't remember exactly what it was, but pretty far away. 62.43 or something, and then 70/47, we are shipping this … and we are out of time.
Liz: We're out of time!
So we are going to come back with Trade Small, Trade Off and stay tuned. We're opening up the phone lines right now, so give us a call.