Using Ratio Back Spread

I have entered many ratio back spreads over the last 3-4 weeks and all of the trades are positive.

This is done to increase the theta gains especially for near term short options. Basically, the delta is neutralized against the Long options or stock and the theta gain is doubled.

Some guidelines:

• Increase 2 x Short term short options help to pay the long option or stock. Sometimes, to be safe, use 1.5X instead of 2X
• The shorts should be OTM preferably about 2 strikes down to prevent it from going ITM.
• Do not use time frame longer than 1 month as it is difficult to predict actions of the stocks. Weekly options are best for this purpose
• Do not use it when there is earning announcement and anticipation of a major volatility event.

Taking the example of a calendar option spread ( Long term Long option + 2X short term short options ), my observations over many trades are:

·       When the trend is against long option, the short option gain is able to offset the loss on long option

·       When the trend is in the direction of the long option, the gain in the long option is higher than the short option because of higher delta.

·       Note that in many cases that the trade makes money when the trend is up or down as long as it does not move too violently.

·       Even if the trend moves violently, it is not difficult to adjust the shorts by rolling it down or putting additional protection. There is enough time to do the adjustment. Volatility in the last few weeks are high enough to verify the trades

·       When the shorts go slightly ITM, the trade will still make money. But it goes ITM, it is a signal to be ready to close the trade, make the secondary exit or adjustment to protect the trade. I do not act on the day when it goes ITM but will initiate my SE once the overall trade turns negative.

I have used these strategies for the following trades

SPY Nov 120 / Oct 119 put calendar : broke even despite entering the put on a totally wrong timing. The trade was entered when SPY was at support at 120!

RIMM – Nov 23 /  Oct 21 ( 2x ) put – rolled to Oct 20 SP and rolled to Nov 19 SP. Trade is making money

IMAX – selling double the puts to pay for the put protection on the stock

FXE – a put calendar  Jan 140 / 135 (1.5X ) bought on 10/28. With all the swings in volatility , the trade is behaving very well. When FXE is up, the gain in the short is higher than the put. When FXE is down, the gain in the long is higher than the shorts.

I have done similar trades for GE, POT, FCX, EUO,APOL ( bear call calendar) – all of them with positive results.

There is an alternative use for the 2 X options. On 2 occasions I used 2 X short term long OTM options to protect any potential big moves in stock before an earning events. It is reasonably cheap that if the trade is in my direction, the trade can still make a profit with this cheap insurance.

The key learning is that using double short option, short term OTM can protect a long trade and help to reduce the cost. The short options theta gains will offset any loss on the long put and the long put gain will normally cover the loss of delta in the short options. It is best used when stock are traded in a range. Nevertheless, the trade can tolerate slightly wider range but not a complete break down or breaking up of price.

There are some risks involved but it is very manageable if the trades are placed OTM. It can take some volatility but still the trade should not be placed before earnings or any anticipated big movement or events.