The following list of option spread strategies features tips 9-12 and picks up where a previous article left off.
These strategies offer a glimpse into unique combinations of options that are aimed at seizing specific investing opportunities. As investors become comfortable with basic options strategies, these possibilities may be worth considering for specific situations.
9) Neutral Calendar Spread
Neutral calendar spread is another neutral market strategy. I am neutral toward the market in the short term. My plan is to take advantage of rapid devaluation of the near-term option because of time decay.
As the name suggests, the spread is based on calendar dates of the same security at the same prices. I will sell one near-term at-the-money call. I will buy one long-term at-the-money call.
|1 long-term at-the-money CALL||
1 near-term at-the-money CALL
My profit is limited to the premiums I collect for selling the near-term option, less the time decay of the longer-term option. All of my profit is paid upon entering the trade.
If the price of the underlying security goes down and stays down until the exercise date of the longer-term option, I lose money. The payment it took to put on the spread is the most that I can lose with this strategy.
This strategy has limited profit potential and limited loss potential. Therefore, other strategies are more useful when seeking big profits.
10) Put Ratio Spread
Put ratio spread is another strategy suited for neutral markets. I buy one in-the-money put, and I will sell two out-of-the-money puts.
|1 in-of-the-money PUT||
2 out-the-money PUTS
This is another strategy with exposure to unlimited risk and a limited profit potential. To maximize the return, the price of the stock must be at the strike price upon expiration of the options I have sold.
The intrinsic value of the long put with either the addition or the subtraction of the credit or the debit of the spread is the maximum profit I can make on this trade.
If the underlying security nosedives and goes below my breakeven point at expiration, the loss exposure with a put ratio spread is virtually unlimited.
11) Ratio Call Write
Here is yet another trading strategy that offers limited profit potential and unlimited loss potential. This form of option spread trade is a bit of an oddball for most traders. Ration call write is a bit strange because I have to own the underlying stock. To execute a ratio call write, I would sell far more calls than the shares that I own. The strategy is called a ratio because I sell the at-the-money call in multiples of the shares I own. I would go long on a security first. Then I might sell two or three or five or ten at-the-money calls for that same security.
BUY (or own)
|100 shares of any stock or security||
2 (or more) multiples of at-the-money CALLS on the same security
In this case, a two-to-one ratio is simply two at-the-money calls for 100 shares I might own. I am buying 100 shares because options are generally bought and sold as contracts of 100 shares each. There are cases when you can trade option contracts for fewer shares. However, those option contracts are not as common as contracts for 100 shares.
It is quite evident that this strategy has more loss exposure than potential to earn a profit. Therefore, the ratio call write strategy is another option trading combination that I do not recommend.
12) Ratio Put Write
Ratio put write is a strategy that I am including here merely for the sake of completeness of the list. I cannot think of any good reason to get involved with a ratio put write trade.
The limited profit potential and unlimited risk with this strategy are obvious. Ratio put write is another strategy that is used in neutral markets. If I expect very little or no movement in the price of the underlying security, this strategy calls for shorting 100 shares of the security and then selling two at-the-money puts.
|short 100 shares||
2 at-the-money PUTS
I consider this strategy to be even worse than the ratio call write. My risk is higher because, in addition to selling puts, I am also shorting 100 shares of stock.
The risk is completely unlimited because if the stock drops below the price of the puts I sold, I am on the hook no matter how far down it goes. Not only that, but I am also on the hook if the price goes above that transaction.
My maximum and only real profit is the sale of the two at-the-money puts minus the commissions I paid.
The risk exposure is very high and the potential profit is limited. Therefore, I do not use or recommend this strategy.
My next article in this series will be Part 5 and feature tips 13-16.
Billy Williams is a 25-year veteran trader and author. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com.