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The Leveraging Strategy of Option Ratio Spreads

The Leveraging Strategy of Option Ratio Spreads
June 07
03:17 2011
options trading

Buying options is one way to gain leverage when trading the FOREX, stocks, or commodities. Buying options can also be quite risky and expensive. Is there a method to lower costs on options buying while still having a massive upside for gain?

Gearing and Leveraging

Before we get into the mechanics of this system we need to understand a key concept of options: Delta.

Delta is a letter of the Greek alphabet. The concept of the Delta is quite simple. For every dollar the share price rises, how far does the option value increase? The Delta is the answer.

Stock XYZ has a share price of $10. We are going to plot the dollar increase for the following call option strike prices that will expire one year from now.

Strike Price$ Option Value$ Delta$ Percent Increase%
7.5 3.60 .79 22
10 2.40 .62 26
12.50 1.63 .48 29
15 1.13 .36 32
17.50 0.74 .26 35

What can we discern from the above table? As the strike price for these call options increase, the Delta decreases. For example, the share price is at $10. If the stock jumps up to $11 per share, the option value will increase by the amount of Delta. Judging by this absolute number alone we might think that the $7.50 strike price is the best option since it will increase by 79 cents in value for every dollar of share price increase. This would be incorrect.

Take note of percentages now. 79 cents is the most in an absolute sense, but based on the value of the option of $3.60 is has the lowest percent gain. The $17.50 strike option gallops a whopping 35% for a one dollar increase in share value. The $7.50 strike price call only rises 22%. The further out-of-the-money our options are the higher leverage we gain with Delta percentages.

How can we use this knowledge to our benefit?

Sell One Option and Buy Three More

What would happen if we wrote and sold one stock option and used the money to buy other options with a higher leveraging ratio?

In this example we will sell an at-the-money call option with a $10 strike price. We gain $2.40 per share from this sale. We now turn around and buy three very far out-of-the-money stock options with a strike price of $17.50. This comes to $2.22 and we still have 18 cents left over. What happens if the stock rises one dollar?

On our sold option we lose $0.62 and on our purchased options we gain $0.78 (3 x $0.26), plus we already have 18 cents left over. Our gain from the one dollar price move is a net 16 cents per share. Keep in mind that we have not even utilized all our proceeds! The net profit is 25% higher than our losses and would be greater if we had enough to purchase a fourth option. Essentially we are financing the purchase of highly leveraged stocks options with the sale of a slower moving stock option.

The Dangers of the Ratio Spread

Ratio spreads is a powerful technique to use if you are expecting a large short term price move. But this can also be deadly if the stock suddenly gets stuck in mud and drags its feet. The out-of-the-money options have much more pronounced time decay than the in-the-money options. As each day and month flies by the purchased options devalue much quicker than the written ones.

For the above reason, you must be expecting a large price move when employing the highly leveraged ratio spread strategy. Also remember that a price move against you also has a highly geared effect.

Of course, if you expect the market to be neutral, you could always reverse this approach and sell many out of the money options while buying an in-the-money option. As long as share prices do not rocket upwards you will have financed a profitable option with other options that will likely not be exercised. This is as close to ‘free money’ as most people will ever see.

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Today’s Day Trader Strategy

One of the most common and destructive mistakes a day trader makes is to simply not follow their plans. Temptation, an “obvious signal”, and just simple greed can lead traders down the road of being undisciplined. This is without a doubt one of the most dangerous mistakes, as traders will often lose more than they originally planned as they raised their amount risked.