Well, the people have spoken and so it shall be done!!!!
I am guessing by the feedback that I received last week that this risk reduction concept is something worth exploring and dare I say mastering if one is to make the leap from padawan learner (Rookie in Star Wars talk) to Jedi Knight (Pro!) of trading.
The request came to further delve into this type of trade known as the back ratio spread. I would say this is a somewhat more advanced type of trade but I also feel that if you have been following this blog up to this point that you may be ready to at least try this trade in your paper trading account.
So, I will go over the rules and the situations that this trade might come in handy and then you can practice this trade in your paper account to see if it fits your trading style. I say this because not all trades work for all traders. We all have different trading personalities and some things will fit nicely and some things may not. A very good example of this is the use of indicators. There are as many indicators as there are types of trades and some traders, both rookies and professionals, like to use indicators and have put systems together that put these indicators to good use. Then there are traders like myself that put less emphasis on the use of indicators and prefer to use the tried and true concepts of support and resistance and basic chart reading to achieve our trading objectives. Neither way is necessarily right or wrong it just is what it is and as long as one develops one’s trading personality then one can find success.
As with any type of trade this trade works well under certain market conditions. These market conditions are as follows…
The Ratio Back Spread requires a STRONG move in the overall direction of the trend. This is similar to a straight call option, magnitude of movement is paramount. As we saw last week this trade functions the same as stock or a Call option in terms of profiting from a move in the right direction.
This trade is aided by the move occurring quickly as well. This trade is Theta negative and therefore loses profitability over the course of time. A big quick movement in the equity is ideal for this type of trade.
This trade works well when we are staring at a breakout situation or a retracement as long as resistance doesn’t stand in our way immediately. This means that we need to have at least an expectation that this equity can move enough to make it worth our while to put on the trade. We can model this by putting the trade into our analyzer and checking out the risk graph and determining where likely resistance might be and basing out logical expectations on that expected move.
This is a very unique trade in the fact that it can be done for a credit and a debit depending on the strikes and the equity used. This will take some experimentation on your part to figure out whether a debit or a credit is best for your situation. This trade can be done very simply by selling the ATM option and buying multiples of the strike next to it, in the case of a bullish trade you will be using call options.
Time is a factor in this trade as it can be with all trades. Just like the regular Call option we need to give this trade more time not less time because we are Theta negative on this trade. So, be sure to give yourself time to be right on the direction. This could mean going out two to three months in time to ensure that Theta doesn’t bite you.
Check out the two charts below and you will see a couple of different scenarios. The first is a debit trade and the second is a credit trade on the same equity. Take special note of the risk involved in the two trades.
In this example this is a debit trade and the max risk comes if the price pins on the long strike at expiration. This trade requires some attention near expiration. The next chart is the same trade except that with a credit.
You can see here that our risk has increased overall but if the trades goes the opposite way we expect then we would collect a small credit. In this case the credit would be approximately $44 per contract. The most important thing to recognize is that the risk actually increased and we were originally talking about reducing risk.
We actually did reduce our risk in the second trade if we are actually wrong on direction but we must calculate our risk on the worst-case scenario and in this case, we almost doubled our overall risk. It is for these reasons that this is a more complex trade and requires more skill to manage.
With the parameters set out here you should be able to build your own Back Ratio Spread to practice in your paper trading account until you gain the necessary skill to go live with something like this.
In next weeks blog we will talk about how we might manage these types of trades. Until then…trade well my friends!