is re-alized only if the underlying instrument is at the strike price of the longoption (60) at expiration. The maximum risk is computed using the fol-lowing formula:
[(Number of short calls × difference in strikes) × 100] – net credit
In this case, the maximum risk equals $1,575: [(2 × 10) × 100] – 425 =$1,575. Now let’s calculate the upside breakeven of this example using thefollowing equation:
Higher strike call + [(difference in strikes × number of short calls)÷ (number of long calls – number of short calls)]– net credit
In this case, the upside breakeven is $75.75: 60 + {[(60 – 50) × 2] ÷ (3 – 2)}– 4.25 = $75.75. The downside breakeven is simply computed by adding thelower  strike  price  of  the  short  options  to  the  net  credit  divided  by  thenumber  of  short  options.  If  a  call  ratio  backspread  is  entered  with  a  net
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FIGURE 9.5 Call Ratio Backspread Risk Proﬁle
debit, there is no downside breakeven. In this trade, the downside breakevenis $52.12: 50 + (4.25 ÷ 2) = 52.12. That means this trade makes money as longas the price of the underlying closes above the upside breakeven. Call ratiobackspreads  are  best  implemented  during  periods  of  low  volatility  in  ahighly volatile market that shows signs of increasing activity to the upside.The risk proﬁle of this trade can be found in Figure 9.5.
Call Ratio Backspread
Strategy: Sell lower strike calls and buy a greater number of higher strikecalls (the ratio must be less than .67).
Market  Opportunity: Look  for  a  market  where  you  anticipate  a  sharprise with increasing volatility; place as a credit or at even.Maximum Risk: Limited. [(Number of short calls × difference in strikes) ×100] – net credit (or + net debit).
Maximum Proﬁt: Unlimited to the upside above the upside breakeven.Upside Breakeven: Higher strike call + [(difference in strikes × numberof short calls) ÷ (number of long calls – number of short calls)] – net credit(or + net debit).
Downside  Breakeven: Lower  strike  call  +  (net  credit  ÷ number  of  shortcalls)]. No downside breakeven exists if the trade is entered with a net debit.
Margin: Varies by brokerage ﬁrm policy.
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Call Ratio Backspread Case Study
Let’s say you’re bullish on eBay (EBAY) and want to set up a strategy thathas limited risk, but high proﬁt potential. During the month of February2003, the stock is trading for $75.25 a share. A call ratio backspread can becreated by going short 2 EBAY January 80 calls at $11 and going long threeEBAY January 90 calls at $6.50. The trade yields a net credit of $250. Therisk graph shown in Figure 9.6 details the risk/reward proﬁle of this trade.Now, let’s do the math. The maximum risk will occur at expiration ifthe stock moves to $90 a share. At that point, the short calls are worth $10each and the long calls expire worthless. So, we lose $2,000 per contractminus the net credit $250, for a maximum risk of $1,750. Since you want toavoid  this  possibility  at  all  costs,  if  the  stock  does  not  move  above  that
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FIGURE 9.6 EBAY Call Ratio Backspread (Source: Optionetics Platinum © 2004)
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Call Ratio Backspread Case Study
Strategy: Short 2 EBAY January 80 calls @ $11 and long 3 EBAY January90 calls @ $6.50. The net credit equals $250.
Market Opportunity: EBAY looks set for an explosive move higher, butthe strategist wants downside protection.Maximum Risk: Limited. [(Number of short calls × difference in strikes) ×100] – net credit. In this case, $1,750: [(2 × 10) × 100] – $250.
Maximum Proﬁt: Unlimited to the upside beyond the breakeven. In thiscase, the proﬁt is $1,410.Upside Breakeven: Higher strike call + [(difference in strikes × numberof short calls) ÷ (number of long calls – number of short calls)] – net credit.In this case, $107.50: 90 + [(10 × 2) ÷ (3 – 2)] – 2.50.
Downside Breakeven: Lower strike call + (net credit ÷ number of shortcalls). In this case, $81.25: 80 + (2.50 ÷ 2).
level within a reasonable period of time, close the trade and move on. Ifthe stock fails to rise or falls sharply, there’s little we can do other thankeep the credit and let the options expire worthless.
Ideally, however, the stock will move higher. The upside breakeven atexpiration is equal to $107.50: 90.00 + [(10 × 2) ÷ (3 – 2) – 2.50 = $107.50.However, we do not intend to hold this position until expiration. Instead,we want to exit the position at least 30 days before expiration or after areasonable proﬁt has accrued.
In this case, eBay did indeed move higher. Six months later, the stockwas trading near $110 a share. Although you would have probably bookedproﬁts long before that time, at $110 a share in August 2003, the long callswould have sold for $25.30 (a proﬁt of $5,640) and the short calls couldhave been bought to close at $33.40 (a loss of $4,480). Thus, the net proﬁtwould have been $1,160 plus the original credit of $250, or $1,410.
PUT RATIO BACKSPREADS
The implementation of a put ratio backspread is a great way to play a bearmarket.  A  put  ratio  backspread  is  a  delta  neutral  (nondirectional  risktrade),  which  allows  us  to  proﬁt  substantially  from  strong  downwardmovement;  however,  we  can  also  hedge  and  protect  ourselves  from  up-ward movement. Thus, if we are incorrect and the stock goes against us,we are in a position where we won’t lose anything, or we may even realizea small proﬁt, depending on how we enter into the trade. I like to use a putratio backspread when I can identify a stock with a bearish bias and expect
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the stock to make a signiﬁcant move. If we are correct and the stock makesa strong move to the downside, we’ll be in a position with limited proﬁt po-tential  (the  stock  can  only  fall  to  zero).  If  we  are  wrong  and  the  stockmoves against us, we can let the options expire worthless, not have to paycommissions to exit, and not lose any money or even make a little if thetrade is placed with a net credit.
Placing  put  ratio  backspreads  on  strong,  downtrending  stocks  willfurther increase your chances of success. As compared with buying stock,they can offer the same unlimited reward potential but also provide youwith limited downside risk. Compared with just buying calls, they can of-fer the same unlimited reward potential with a lower breakeven and lesscost. Also, this trade helps to counter some of the impact from volatility inthe  markets,  which  allows  us  to  place  the  trade  after  news  has  alreadycome out on a particular stock.
A put ratio backspread strategy is created by selling a certain numberof higher strike puts and simultaneously buying multiples of a lower strikeput. This position is created in a ratio such that you sell fewer calls thanyou buy in a ratio of .67 or less. For instance, a 1 × 2 consists of one shortput and two long puts. Similarly, you can create a 2 × 3, 3 × 5, or any com-bination trade with a ratio less than .67.
Put ratio backspreads are best placed in markets with a forward volatil-ity skew. In these markets, the higher strike options (the ones you want tosell) have higher implied volatility and can be overpriced. The lower strikeoptions (the ones you want to buy) enjoy lower implied volatility and are of-ten underpriced. By trading the forward volatility skew, you can capture theimplied volatility differential between the short and long options.
We want to make sure we give ourselves enough time to be right inthis trade. The more time we can buy the better. With diligent research wecan  pinpoint  good  put  ratio  backspread  trades  with  longer  time  framesand many times can even use LEAPS. Also, if we can’t get in at even or fora small credit, then we shouldn’t take the trade.
Although this trade can be entered for a small credit, there is still awindow of risk. The maximum risk occurs when the stock is at the longstrike  on  the  expiration  date.  The  broker  will  require  and  hold  the  riskamount as collateral in your account through the duration of the trade asprotection from the worst-case scenario at expiration.
You can use the put ratio backspread to protect any long-term bullishpositions and even sell out-of-the-money calls to create an appreciating col-lar position—a very nimble strategy indeed (covered in Chapter 10).
Taking into account the put ratio backspread advantages, which arepotentially large proﬁts on the downside, you can control the risk by howlong you stay in the trade. And having a much lower risk than a long putdirectional  trade,  along  with  the  ﬂexibility  of  using  it  to  create  a  collar,
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makes this a strategy worth evaluating when looking for bearish and pro-tective strategies.
To reduce confusion, let’s use the same numbers as the XYZ call ra-tion  backspread  example  to  demonstrate  a  put  ratio  backspread.  Usingthis  strategy,  we’ll  sell  a  higher  strike  put  and  buy  a  greater  number  oflower strike puts. The strikes are the same as before: 40, 45, 50, 55, and 60.The 60 put is the highest strike and comes with the highest intrinsic valueand 40 is the lowest.
Using  this  scenario,  I  could  place  a  wide  variety  of  put  ratio  back-spreads. To further complicate the situation, I could do different ratios oneach combination. For this example, I’m going to sell the 60 put and buy agreater number of 55 puts. If the market crashes, I’ll lose money to the 55point; but below 55 I’ll be making more on the 55 puts than I lose on the 60puts because I have more of the 55 puts.
This actually happened to me once in the S&P 500 futures market. If youthink the S&P 500 futures market is moving into lofty levels and you don’twant to gamble a lot, you could do a put ratio backspread. I was lucky. Themarket moved down so fast that month that I made a lot of money. Similarly,if you had placed a put ratio backspread the day the market crashed back in1987, you wouldn’t need to read this book. You’d be in Aruba, the Bahamas,or somewhere equally relaxing. You’d be laughing all the way to the bank.
Put Ratio Backspread Mechanics
Let’s take a look at the mechanics of a put ratio backspread. A put ratiobackspread  is  composed  of  the  sale  of  a  higher  strike  put  and  the  pur-chase of a greater number of lower strike puts. This strategy is best imple-mented at periods of low volatility in a highly volatile market when youanticipate increasing market activity to the downside (bearish).
In placing these kinds of trades, it is essential to create the most effec-tive  ratio  in  markets  with  increasing  volatility,  liquidity,  and  ﬂexibility.Let’s  create  a  new  put  ratio  backspread  trade  using  XYZ  at  $50  a  shareduring the month of February and look at the January LEAPS two yearsout. Strike prices on the LEAPS are available at 5-point increments. Forexample, with XYZ trading at $50, the available strikes are 40, 45, 50, 55,and so on. Any put options with strikes above 50 are in-the-money; put op-tions with strikes below 50 are out-of-the-money.
Let’s  create  a  put  ratio  backspread  by  selling  two  January  2005  50puts at $8 and buying ﬁve January 2005 40 puts at $3. The short puts gen-erate a credit of $1,600: (2 × $8) × 100 = $1,600. The long puts cost only$300 each or a $1,500 debit. If we divide $1,600 by $300 a contract, we canafford to purchase ﬁve long put options and still have a net credit of $100.This generates a ratio of 2-to-5, which satisﬁes the rule of creating ratios
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less than .67. To calculate the risk, multiply the number of short contracts(2) by the difference in strike prices (10), by the multiplier (100), plus anydebit paid (0) or minus any credit received ($100). This gives us a maxi-mum risk of $1,900: [(2 × 10) × 100] – 100 = $1,900). The risk proﬁle of thistrade is shown in Figure 9.7.
As you can see, we have created a trade with limited reward (the stockcan only fall to zero) and a maximum risk of $1,900. Once again, the maxi-mum risk will be realized only if the underlying stock at the time of expira-tion  is  equal  to  the  long  strike  price.  The  upside  breakeven  is  the  higherstrike put option minus the net credit divided by the number of short puts.In this case, the upside breakeven is 49: [50 – (1 ÷ 2) = 49.50]. If the stockcloses above $50 a share, the options expire worthless, but you can keepthe credit. The downside breakeven is calculated using the following equa-tion: Lower strike minus the number of short contracts times the differencein strike prices divided by the number of long options minus the number ofshort options plus the net credit (or subtract the net debit). In this trade, thedownside breakeven is 34.33: 40 – [(50 – 40) × 2] ÷ (5 – 2) + 1 = 34.33. Thistrade makes money as long as the price of the underlying closes below thedownside breakeven. If the trade had been entered with a net debit, the up-side breakeven would not exist.
This  put  ratio  backspread  works  because  the  further  the  market  getsaway from the strike where you originally purchased the options, the moremoney the trade will make. As each level of option gets further in-the-money,
FIGURE 9.7 Put Ratio Backspread Risk Proﬁle
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Put Ratio Backspread
Strategy: Sell higher strike puts and buy a greater number of lower strikeputs with a ratio less than .67.
Market Opportunity: Look for a market where you anticipate a sharp de-cline with increased volatility; place as a credit or at even.Maximum Risk: Limited [(number of short puts × difference in strikes) ×100] – net credit (or + net debit).
Maximum  Proﬁt: Limited  to  the  downside  below  the  breakeven  (as  theunderlying can only fall to zero).
Upside  Breakeven: Higher  strike  put  –  (net  credit  ÷ number  of  shortputs). No upside breakeven exists if the trade is entered with a net debit.Downside Breakeven: Lower strike price – [(number of short puts × dif-ference in strikes) ÷ (number of long puts – number of short puts)] + netcredit (or – net debit).
Margin: Varies by brokerage ﬁrm policy.
the delta of the options purchased will become greater than the delta of theoptions sold. In other words, the further an option is in-the-money, the moreit acts like a stock. The risk graph of this example is shown in Figure 9.7.
Put Ratio Backspread Case Study
In  this  chapter’s  ﬁnal  case  study,  we  are  considering  a  put  ratio  back-spread on Intel (INTC). In this case, it’s February 2004 and we’re worriedthat the stock is due for a sharp fall. However, if we’re wrong, we don’twant to lose our shirt.
The stock is trading for exactly $30 a share and we set up a 1-to-2 putratio backspread composed of the purchase of two INTC January 2005 25puts @ $1.50 and the sale of one January 2005 30 put @ $3.50. The tradeyields a $50 credit. If the stock rallies rather than falls, we can do nothing,keep the credit, and let the puts expire worthless.
Ideally, however, the stock will move below the downside breakeven.At expiration, the downside breakeven is equal to the lower strike priceminus the difference in strike prices times the number of short puts plusthe credit, which equals $20.50: $25 – (5 × 1) + .50 = $20.50. The maximumrisk occurs if the stock closes at the lower strike price at expiration. Atthat  point,  the  short  call  is  $5  in-the-money,  but  the  long  call  expiresworthless. However, just as with the call ratio backspread, we do not wantto hold this position until expiration. Instead, we want to exit the position30 days before expiration or after a reasonable proﬁt. The risk proﬁle ofthis trade is shown in Figure 9.8.
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FIGURE 9.8 INTC Put Ratio Backspread (Source: Optionetics Platinum © 2004)
Put Ratio Backspread Case Study
Strategy: Short  1  INTC  January  30  Put  @  $3.50  and  Long  2  January  25Puts @ $1.50. The net credit equals $50.
Market  Opportunity: We want to hedge in case Intel moves lower, butnot lose if it continues to move northward.Maximum Risk: Limited [(number of short puts × difference in strikes) ×100] – net credit. In this case, $450: [(1 × 5) × 100] – $50.
Maximum Proﬁt: Limited to the downside beyond the breakeven (as thestock can only fall to zero) plus the credit.
Upside Breakeven: Higher strike – (net credit ÷ number of short puts). Inthis case 29.50: [30 – (.50 ÷ 1)].Downside Breakeven: Lower strike – (number of short puts × differencein strikes) ÷ (number of long puts – number of short puts) + net credit. Inthis case, the DB is 20.50: 25 – [(1 × 5) ÷ (2 – 1)] + .50.
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EXIT STRATEGIES FOR RATIO BACKSPREADS
Whether trading call or put ratio backspreads, the strategist wants to con-sider the possibility of early assignment on the short options. This can oc-cur  if  the  short  options  have  little  time  value  left.  As  a  general  rule,  anoption with a quarter point or less of time value will have a relatively highprobability of assignment. At that point, it might be wise to close the back-spread. In addition, we generally recommend exiting ratio backspreads 30days prior to the options’ expiration.
Here  are  a  few  exit  rules  to  follow  when  dealing  with  put  or  callbackspreads.  First,  if  the  trade  has  a  reasonable  proﬁt  (50  percent  ormore), consider closing out an equal number of short and long positions.Then, the remaining long option is working with free money and can beheld for additional proﬁts. Second, if the underlying stock rises betweenthe  upside  and  downside  breakevens,  exit  the  entire  position  with  30days  or  less  left  until  expiration.  To  do  so,  buy  the  short  options  backand sell the long options. In that case, try to mitigate the loss. Third, it isrecommended that you close out the position before 30 days of expira-tion unless you feel strongly that the stock will continue to increase (in acall  backspread)  or  decrease  (in  a  put  backspread).  If  the  underlyingstock falls below the downside breakeven in a call ratio backspread orabove the upside breakeven in a put ratio backspread, let the options ex-pire worthless.
VOLATILITY SKEWS
There  are  two  types  of  volatility  skews  that  can  develop  in  an  optionsclass. The ﬁrst type is known as a time skew and arises when the impliedvolatility  of  one  month  is  signiﬁcantly  different  from  the  other  months.This often happens when there is a takeover rumor or some other eventthat causes the implied volatility of the short-term options to move higherrelative to longer-term options. When this happens, the strategist can at-tempt to take advantage of the time skew with a calendar spread, whichinvolves buying the options with the low implied volatility (IV) and sellingthe options with the high IV. The strike prices of the two options contractsare the same, but the expiration months are different.
The second type of volatility skew is known as a price skew. With thistype of skew, the expiration months are the same. However, there is a sig-niﬁcant difference in implied volatility along the various strike prices. Forexample, if the at-the-money options have a much higher implied volatilitythan the out-of-the-money options, the result is a price skew.
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Going  further,  there  are  two  types  of  price  skews.  With  a  forwardprice skew, the options with the higher strike prices have higher levels ofimplied  volatility  than  the  options  with  lower  strike  prices.  A  reversevolatility  skew,  in  contrast,  occurs  when  the  lower  strike  prices  have  ahigher volatility skew than the options with the higher strike price.
Traders  can  sometimes  use  forward  and  reverse  volatility  skews  totheir advantage. The goal is to sell those options with the higher impliedvolatility and buy the ones that have the lower IV because the ones withthe higher implied volatility are considered more expensive. For instance,if  a  strategist  identiﬁes  a  forward  volatility  skew,  they  can  attempt  toproﬁt with a put ratio backspread, which involves buying the options withthe lower strike price and selling the options with the higher strikes. Callratio backspreads make more sense when the strategist identiﬁes a reverseskew.  At  that  point,  they  would  want  to  sell  the  options  with  the  lowerstrike price and buy a greater number of the higher strike options.
STRATEGY ROAD MAPS
Ratio Call Spread Road Map
In order to place a call ratio spread, the following 12 guidelines should beobserved:
1. Look for a market where you expect a decline (to keep the net credit)or a slight rise not to exceed the strike price of the short options.
2. Check to see if this stock has options available.3. Explore past price trends and liquidity by reviewing price and volume
charts over the past year.
4. Review  options  premiums  per  expiration  dates  and  strike  prices.Place the position as a credit or as close to at-even as you can. Use op-tions with greater than 90 days until expiration. LEAPS options are agood  choice  since  they  provide  an  opportunity  for  time  to  work  inyour favor.
5. Investigate  implied  volatility  values  to  see  if  the  options  are  over-priced or undervalued. This strategy is best placed in markets with areverse volatility skew. In this environment, the higher strike options(the ones you want to sell) have higher implied volatility and can beoverpriced. The lower strike options (the ones you want to buy) enjoylower  implied  volatility  and  are  often  underpriced.  By  trading  thereverse volatility skew, you can capture the implied volatility differen-tial between the short and long options.
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6. A ratio call spread is composed of buying the lower strike call (ITM orATM) and selling a greater number of higher strike calls (OTM). De-termine which spread to place by calculating:
• Unlimited Risk: Unlimited to the upside above the breakeven.• Limited Reward: Limited. [Number of long contracts × (difference
in strikes × 100)] + net credit (or – net debit).
• Upside  Breakeven: Lower  call  strike  price  +  [(difference  instrikes × number  of  short  contracts)  ÷ (number  of  short  calls  –number of long calls)] + net credit (or – net debit).
• Downside Breakeven: None when established for a credit.
7. Create  a  risk  proﬁle  of  the  most  promising  option  combination  andgraphically  determine  the  trade’s  feasibility.  A  call  ratio  spread  riskproﬁle shows an unlimited risk above the upside breakeven and a lim-ited reward.
8. Write down the trade in your trader’s journal before placing the tradewith your broker to minimize mistakes made in placing the order andto keep a record of the trade.
9. Make an exit plan before you place the trade. How much money is themaximum  amount  you  are  willing  to  lose?  How  much  proﬁt  do  youwant  to  make  on  the  trade?  For  example,  exit  the  trade  when  thestock moves above the maximum proﬁt level at any time prior to 30days before expiration.
10. Contact your broker to buy and sell the chosen options. Place thetrade  as  a  limit  order  so  that  you  limit  the  net  credit/debit  of  thetrade.
11. You  do  have  to  watch  the  market  closely  on  this  type  of  trade.  The
proﬁt on this strategy is limited, but the risk is unlimited.
12. Choose an exit strategy based on the price movement of the underly-ing stock and ﬂuctuations in the implied volatility of the options:
• The underlying stock exceeds the short strike price: Oncethe  stock  has  made  a  move  higher,  watch  carefully  for  any  fur-ther moves higher. Exit the strategy if the stock moves either (1)above  the  maximum  proﬁt  level  or  (2)  above  the  upsidebreakeven.
• The  underlying  stock  falls  below  the  downside  breakeven:
Keep the credit and let the options expire.
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Ratio Put Spread Road Map
In order to place a