Ever heard of a front ratio spread? It's not exactly a common option-trading strategy, even among advanced options veterans. But, it may be just the thing you're looking for to dial back your overall risk and bolster your overall net returns.
Simply put, a front ratio spread is an options trading strategy that involves buying and selling options at different strike prices and expiration dates, with the goal of generating a profit from the difference in premiums paid and received. That sounds like any ordinary spread trade. There's a big "but," however. A front ratio spread involves buying one option, and selling two option contracts, or buying two contracts for every one option you sell… a ratio.
It's not nearly as complex as it might seem it is on the surface though. As was noted, the goal is simply generating a profit from the difference in premiums paid and received. You can use puts or call, and they can be credit spreads or debit spreads. You just trade options on a 2-for-1 basis just to better balance your overall risk and reward.
As always, an example will help you make more sense of the strategy.
Let's say you believe that the stock price of Company ABC is overpriced and you expect it to decline in the near future. Here's how to profit from this view with a front ratio spread:
- Sell a call option with a strike price of $100 that expires in two months for a premium of $5 per share. (This means you receive a net credit of $500, as each option contract typically represents 100 shares._
- Buy a call option with a higher strike price of $110 that also expires in two months for a premium of $3 per share. (This means you pay a net debit of $300.)
The math of the hypothetical spread would look like this:
- Sell 1 ABC call option with a strike price of $100 and expiration in two months for a premium of $5 per share, receiving a net credit of $500
- Buy 1 ABC call option with a strike price of $110 and expiration in two months for a premium of $3 per share, paying a net debit of $300
Net result? A credit of $200….$500 credit from selling the call minus $300 debit from buying the call.
If the stock price of Company ABC remains below the $100 strike price at expiration, both options expire worthless and you keep the $200 credit as profit. However, if the stock price rises above the $100 strike price, the option you sold will be in the money, and you may be assigned to sell your shares at $100, while the option you bought will be out of the money and expire worthless, limiting your potential loss.
Bottom line? this front ratio spread allows you to profit if the stock price of Company ABC declines or remains below $100, while limiting your potential loss if the stock price rises above $100.
A bearish-to-neutral front ratio spread doesn't necessarily have to a credit spread using calls, however. They can be debit spread trades as well, as well as use puts. And, they can be bullish.
Example? Let's now assume you believe that the stock price of Company ABC is going to rise in the near future, you can use a front ratio bullish debit spread to profit from this expectation:
- Buy a call option with a strike price of $100 that expires in two months for a premium of $5 per share. (This means you pay a net debit of $500, as each option contract typically represents 100 shares.)
- Sell two call options with a higher strike price of $110 that also expire in two months for a premium of $2 per share. (This means you receive a net credit of $400 … 2 options x 100 shares x $2 per share.)
The resulting front ratio bullish debit spread would look like this:
- Buy 1 ABC call option with a strike price of $100 and expiration in two months for a premium of $5 per share, paying a net debit of $500
- Sell 2 ABC call options with a strike price of $110 and expiration in two months for a premium of $2 per share, receiving a net credit of $400
The net cost is a debit of $100… $500 debit from buying the call option, offset by $400 credit from selling two call options.
So, let's think this through. If the stock price of Company ABC rises above the $110 strike price at expiration, both options expire worthless and you lose the $100 debit paid. However, if the stock price increases between the $100 and $110 strike prices, the option you bought will be in the money, and you can exercise it to buy 100 shares at $100, while the two options you sold will be out of the money and expire worthless, limiting your potential loss.
Connecting the dots, this front ratio bullish debit spread using calls allows you to profit if the stock price of Company ABC rises or remains between the $100 and $110 strike prices, while limiting your potential loss if the stock price decreases or remains below $100.
Overall, front ratio spreads can be a useful options trading strategy for traders who want to limit their risk while generating income. However, as with any trading strategy, there are potential risks and rewards to consider before implementing this strategy. It's important to have a thorough understanding of the strategy and the risks involved before placing any trades. They are….
Pros:
- Risk management: Front ratio spreads can limit the potential loss of a trade, as the sale of additional options can offset the cost of the purchased options.
- Flexibility: This strategy can be used in bullish, bearish, or neutral market conditions and can be implemented using either call or put options.
- Income generation: Selling options can provide traders with an additional source of income.
Cons:
- Limited profit potential: The potential profit of a front ratio spread is limited, as the profit is capped at the difference between the strike prices minus the net debit or credit paid for the options.
- Higher transaction costs: Trading multiple options contracts can result in higher transaction costs, reducing the potential profits of the trade.
- Complex strategy: Front ratio spreads can be more complex to implement compared to simpler options strategies, requiring traders to have a good understanding of options trading concepts.
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