35 lines
2.7 KiB
Plaintext
35 lines
2.7 KiB
Plaintext
Chapter 11: Ratio Call Spreads 213
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the 6 points that the call would be worth less the 1-point initial net credit - a total of
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$1,520 for this spread ($1,020 + $600 - $100).
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DIFFERING PHILOSOPHIES
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For many strategies, there is more than one philosophy of how to implement the
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strategy. Ratio spreads are no exception, with three philosophies being predominant.
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One philosophy holds that ratio spreading is quite similar to ratio writing - that one
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should be looking for opportunities to purchase an in-the-money call with little or no
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time premium in it so that the ratio spread simulates the profit opportunities from
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the ratio write as closely as possible with a smaller investment. The ratio spreads
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established under this philosophy may have rather large debits if the purchased call
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is substantially in-the-money. Another philosophy of ratio spreading is that spreads
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should be established for credits so that there is no chance of losing money on the
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downside. Both philosophies have merit and both are described. A third philosophy,
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called the "delta spread," is more concerned with neutrality, regardless of the initial
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debit or credit. It is also described.
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RATIO SPREAD AS RATIO WRITE
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There are several spread strategies similar to strategies that involve common stock. In
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this case, the ratio spread is similar to the ratio write. Whenever such a similarity
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exists, it may be possible for the strategist to buy an in-the-money call with little or no
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time premium as a substitute for buying the common stock. This was seen earlier in
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the covered call writing strategy, where it was shown that the purchase of in-the
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money calls or warrants might be a viable substitute for the purchase of stock. If one
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is able to buy an in-the-rrwney call as a substitute for the stock, he will not affect his
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profit potential substantially. When comparing a ratio spread to a ratio write, the max
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imum profit potential and the profit range are reduced by the time value premium
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paid for the long call. If this call is at parity (the time value premium is thus zero), the
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ratio spread and the ratio write have exactly the same profit potential. Moreover, the
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net investment is reduced and there is less downside risk should the stock fall in price
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below the striking price of the purchased call. The spread also involves smaller com
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mission costs than does the ratio write, which involves a stock purchase. The ratio
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writer does receive stock dividends, if any are paid, whereas the spreader does not.
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Example: XYZ is at 50, and an XYZ July 40 call is selling for 11 while an XYZ July 50
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call is selling for 5. Table 11-2 compares the important points between the ratio write
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and the ratio spread. |