Walking Down the Spreads Line

This is the monthly spreads commentary on commodities. Are you tired of spending money on hedges? Do you comfort yourself by viewing buying puts as “insurance” against losses? Would you rather have a hedging strategy that can actually place money back into your pocket if the hedge is not needed? Introducing ratio spreads! This is a hedging strategy so successful that some equity traders use it as their go-to method of trading. Can it lose? Of course it can, but avoiding that scenario is not difficult. Let’s examine this miraculous spread.

Most spreads are balanced, in the sense that the number of long positions equals the number of short positions. Ratio spreads are never balanced. The “ratio” part of their name refers to the ratio between the number of long and short positions, and it is never 1:1. The most common ratio is 2:1 (read as “2 to 1”), although 3:2 happens occasionally. Here is how a 2:1 ratio spreads works. Other ratio spreads work similarly.

Start with the ticker of a commodity you want to hedge, say XYZ, and suppose you want to hedge against it going down, which is typical for commodities. The process works best when the volatility of XYZ is high, for a number of reasons. First, the option prices will be higher, and a greater profit is earned. Second, because the difference in the bought and sold options can be smaller, and that makes the trade easier to handle. And third, a large IV happens when the underlying price is moving faster, and that can mean bigger profits. Pick an expiration date that is at least a month out. (Obviously, hedging this close to the harvest is not going to work for this season.) Look at the put options on the futures for that date. You now pick a pair of strike prices with this property: the OTM strike cost is more than half the cost of the ITM strike. You then sell 2 of the OTM strike options and, at the same time, buy 1 option of the ITM strike. (All options have the same expiration date.) This means the transaction has a credit.

We now analyze the profit/loss graph of this transaction at the expiration date, starting above the ITM (bought) strike and working down. Here is the graph of the profit and loss when the options all expire.

For prices of XYZ above the bought strike, all puts will expire worthless, and the net profit is the cost (profit) of the spread. As the price of XYZ drops, the single bought put will lose money steadily (the sold puts still expire worthless), until the profit curve crosses the profit=0 line, the larger breakeven price. As the price of XYZ continues dropping to the sold strike price, the profit line continues to show greater losses. When the sold strike price is reached, that is the maximum loss. As the price continues to drop, the two sold puts gain money twice as fast as the bought put loses it, and the profit line turns back up again, now gaining money as fast as it was losing it before. The profit line again crosses the profit=0 line, at the smaller breakeven price. The profit line then increases steadily until the price of XYZ hits 0.

The trade loses money only between the two breakeven prices. That interval is sometimes referred to as the “valley of death.” We will come back to that later.

Note the characteristics of the profit curve. As the price of XYZ moves up, and the hedge is not needed, the trade eventually gets above the bought strike, and the cost stays steady at the profit for placing the hedge. And as the price moves down below the lower-priced breakeven, the value of the hedge increases as the price drops. That’s better than the vertical spread can do, in both directions!

But what about that accurately-named valley of death? It is now clear why we would want the IV to be large, to make the valley narrower. The risk involved in getting caught there is usually a lot more than the profit from initiating the trade. But the ratio spread has another trick up its sleeve! The valley of death is real, but only fully exists at the time of expiration. In practice, the valley doesn’t really form fast. It can go negative, but normally not until about two weeks or less before expiration, when the downward pressure in prices chews through the profit. The resolution of the problem of the valley of death is simple: If you are anywhere close to the valley of death, especially between the breakeven prices, exit the trade before the valley forms, at least a week or two before the expiration.

For equity traders, this same strategy can be used. If you want to short a stock, the instructions above work exactly. If you want to go long an equity, you only need to use calls instead of puts, and make the few adjustments needed for the change. Note, of course, that these are useful for traders and not appropriate for investors, as with almost all option strategies. Also, equity traders sometimes invert this process, flip the profit graph upside down by reversing what is bought and sold, and hope that the price stays inside the inverted (and now profitable) valley of death. This strategy does work on stocks with low volatility, but I view it as riskier.