38 lines
3.0 KiB
Plaintext
38 lines
3.0 KiB
Plaintext
484 Part IV: Additional Considerations
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The risk trader can also use the neutral spread ratio to his advantage. This con
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cept was illustrated several times in previous chapters describing ratio writing, ratio
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spreads, and straddle writes. Ratio spreads are quite popular with member firm
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traders and floor traders. Recall that a ratio spread consists of buying options at acer
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tain strike, and selling more options further out-of-the-money. The hedge ratios can,
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of course, be used by the trader, or by a public customer, to initially establish a neu
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tral position. Perhaps more important, the hedge ratio can also be used as a follow
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up action to keep the position neutral after the stock changes in price. This strategy
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is the "delta spread" described in Chapter 11.
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The risk trader is not attempting to establish the spread with the idea of mini
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mizing risk for small stock movements. Rather, he is looking to make a profit, but
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would prefer to remain as neutral as possible on the underlying stock. He is imple
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menting a risk strategy that has a neutral outlook on the underlying stock. He is sell
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ing much more time value premium than he is buying.
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Example: The purchase of 15 January 30 calls and the sale of 30 January 35 calls - a
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ratio call spread - may be a position taken for profit potential. It would be a neutral
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position if the deltas were .60 and .30, for example. This spread would do best if the
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stock were at exactly 35 at expiration. However, if the stock rose quickly before expi
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ration, the spread ratio would decrease from 2:1 to perhaps 3:2. That is, the neutral
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ratio between the January 30 call and the January 35 call should be 3 short January
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35's to 2 long January 30's. If the trader wants to balance his position, he could buy 5
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more January 30's, giving him a total of 20 long versus the 30 short January 35's that
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he originally sold. Conversely, if the stock dropped in price, the neutral spread ratio
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might increase, indicating that more calls should be sold. For example, if this stock
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declines, the neutral ratio might be 3:1. In that case, 15 more January 35's could be
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sold, making the position short 45 calls versus 15 long calls, which would produce the
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neutral 3:1 ratio.
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It would not be proper to adjust the ratio constantly, because the frequent
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whipsaw losses on trading movements would wipe out the profit potential of the posi
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tion. However, the trader may want to pick out points, in advance, at which he wants
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to reevaluate his position before something drastic goes wrong. For example, if the
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foregoing spread were established with the stock at a price of 30, the spreader might
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want to readjust at 33 or 27, whichever comes first.
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By monitoring the spread using the hedge ratio, the trader may also be able to
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discern whether he has established too bullish or too bearish a position.
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Example: The trader starts with the example described above - long 15 January 30
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calls and short 30 January 35 calls - when the hedge ratios were .60 and .30, respec- |