Ratio Vertical Example
Let’s examine a trade of 20 contracts by 40 contracts. Exhibit 16.5 shows
the greeks for this ratio vertical.
EXHIBIT 16.5 Short ratio vertical spread greeks.
Before we get down to the nitty-gritty of the mechanics and management
of this trade—the how—let’s first look at the motivations for putting the
trade on—the why. For the cost of 1.00 per spread, this trader gets a
leveraged position if the stock rises moderately. The profits max out with
the stock at the short-strike target price—$75—at expiration.
Another possible profit engine is IV. Because of negative vega, there is
the chance of taking a quick profit if IV falls in the interim. But short-term
losses are possible, too. IV can rise, or negative gamma can hurt the trader.
Ultimately, having naked calls makes this trade not very bullish. A big
move north can really hurt.
Basically, this is a delta-neutral-type short-volatility play that wins the
most if the stock is at $75 at expiration. One would think about making this
trade if the mechanics fit the forecast. If this trader were a more bullish than
indicated by the profit and loss diagram, a more-balanced bull call spread
would be a better strategy, eliminating the unlimited upside risk. If upside
risk were acceptable, this trader could get more aggressive by trading the
spread one-by-three. That would result in a credit of 0.05 per spread. There
would then be no ultimate risk below $70 but rather a 0.05 gain. With
double the naked calls, however, there would be double punishment if the
stock rallied strongly beyond the upside breakeven.
Ultimately, mastering options is not about mastering specific strategies.
It’s about having a thorough enough understanding of the instrument to be