The Ratio Put Spread – Illustrated with Salesforce.com

• Posted by Greg Harmon
• on November 18th, 2011

There are many different strategies that I use with options and over the next few weeks I will continue to go through some of them to help explain the strategy and how it can be used to access the market with controlled risk. The first two in this were the Call Spread Risk Reversal and the Put Butterfly (links below). Today’s is the Ratio Put Spread.

Ratio Put Spread

This strategy consists of buying one Put Option, selling 2 lower Strike Puts to create the Ratio Put Spread. The sold Puts can be the same Strike or different Strikes, making it a split ratio. It can also be done with a 3:1 or 4:1 ratio, but 2:1 is the most common. This trade is entered when there is a conviction on a downward move but timing is not completely clear or the cost of a Straight Put Spread is relatively high compared to the profit potential or both, so the trader want to commit limited or no capital. Often these trades can be entered for a credit. The Strikes are chosen to maximize the potential profit against gaining the most protection from the short Puts. This is where the Split Ratio can be a great aid by gaining better protection from being put the stock, by selling a put further down in support of the stock. The maximum gain is the difference between the long and short Put, just like a normal Put Spread, and the in a Split Ratio it is retained all the way until the lower Strike sold Put, where it starts to tail off dollar for dollar with the stock price. Since it is net short a Put it requires margin and expose you to owning the stock on a close below the lowest Strike sold Put. but if you are Put the stock it will be at a basis that is reduced by the profit from the initial Put Spread. Confusing? Lets look at an example from a trade we took last night on Salesforce.com, $CRM.

Salesforce.com, $CRM, was looking a bit tired heading into earnings tonight. The daily chart below from midday showed another bounce off of the resistance area at 138.50 earlier in the week and a couple of long red candles since. The Relative Strength Index (RSI) was muddling along at the mid line and the

Moving Average Convergence Divergence (MACD) indicator was negative, but barely. A slight bias to the downside from this timeframe. Support lower comes at 126.75 then 123, followed by 120 and 117.50, 112 and 110.00. Resistance now come at 130.10, 133 and 135 before the 138.50 area and 143 followed by 147 after it. The weekly chart (not shown) presented the shorter Simple Moving Averages (SMA) rolling lower with a break below 130.8 a 200% retrace of the 2008 and the significance of the 110 level as 161.8% of that move. The RSI on that time frame had risen back to the mid line but stalled, still bearish and the MACD has stalled as it made it back to zero. The Options board favored the downside with the Put/Call ratio at 1.46 overall and near 3:1 on the November 18 Expiry. The at-the-money Straddle suggested a move of $13 or just over 10% creating a range of 116-141 expected by Friday, with implied Volatility at over 200% compared to historical at 46% and December at 76%. Bearish plays were in order.

Trade Idea: Buy the November 125/120-110 1×2 Put Spread

Buy the 125 Put and sell both the 120 Put and the 110 Put. This exposes you to owning the stock on a close tomorrow below 110 with a basis of 105, 18% below the current price of 128.05. I bought it for 15 cents near midday. The key to this trade was the support at 110 allowing the sale of the 110 Put and the purchase of the 125/120 Put Spread, combining to the 125/120-110 Split Ratio Put Spread. This stock did move lower touching 110.81 before bouncing in the after hours market and closing at 117.99. Friday morning it was flirting around the 120 level just before the open. Shortly after the market opened I sold the spread combinations for $4.45, for a profit of $4.30 and a great end to the week.

The Put Butterfly – Illustrated with Nordstrom

The Call Spread Risk Reversal – Illustrated with Leap Wireless

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