Hello again, I hope your Sunday has been filled with God’s blessings and you’re finding some time to relax. 2024 is off to the races and here we are already in May. Where does the time go? In less than a month we’ll already be halfway through the year and I just can’t seem to get my head around that today.
In any case, I’ve been seeing more and more headlines making the case for bearishness across the market. It seems there is no shortage of bad news out there to interrupt us as we invest. As such, I thought today I’d share with you a simple strategy, using options of course, to hopefully help us all sleep a little easier.
Let me show you how I’m considering the options ratio spread for portfolio protection. The link provided is a primer from the Chicago Mercantile Exchange.
Today’s Agenda
- Introduction to the options ratio spread
- Options ratio spread expectations
- Building my ratio spread
- How much protection do I need?
Options Ratio Spread – Introduction
The ratio spread, like so many options positions, can be traded many different ways. How they’re structured, depends on the investors market thesis. For this post, we’ll limit our focus to creating a bearish spread. However, just remember they can be structured to support any market hypothesis.
The spread, or any variation of it, is just an unequal number of short calls/puts and long calls/puts. For example, assume we were bearish because news has come out that we’re on the brink of war with Iceland. Who knows, crazier things have happened. Therefore, we decide to sell 1 put option ATM and buy 2 OTM put options. This effectively creates a payoff diagram that would capitalize on the bearish expectation.
Alternatively, the investor could choose any number of long to short puts. So long as the number remained unequal and there were more long puts than short puts our bearish intention would remain. Be careful though, don’t get the ratio backwards.
For illustration, here is the payoff diagram for a similar -1 ATM/ 2 OTM ratio spread.
In this example, notice the infinite upside to the downside. That sounds strange. Regardless, if the market falls as we were expecting then we would have successfully protected our portfolio. In the next section, we’ll focus on what we can expect from the options ratio spread.
Ratio Spread Expectations
I know I’m not alone in the camp of people who’ve hedged their portfolios only to watch the market rip higher and shrug off poor news. Over the past 10 or so years this has happened literally every time. In fact, my poorest performing options trade of all time is the bear call spread. Honestly, I can’t remember the last time I traded one profitably. Nonetheless, the point I’m trying to make is that most hedges produce an unacceptable drag on returns. One bad hedge, not really a big deal. 10 years of bad hedges, kind of a big deal. Thus, why I think options ratio spreads are potentially attractive.
For instance, suppose we are still bearish because of that war with Iceland. The market has become range bound as investors wait to hear what’s ahead. During that time we became concerned of Iceland’s military might and decide to buy a few puts for protection. However, after a few weeks of hawkish rhetoric and choppy markets, peace has ultimately been decided. Our puts have flat lined and the market soars on the good news. Wasted money, in my opinion, and certainly no chance of profiting on those puts.
Alternatively, assume we open an appropriate amount of ratio spreads to hedge our portfolio. Those weeks go by with nothing more than some strong talk and when we see the market is advancing we close for a fraction of the cost or possibly a small profit.
My Ratio Spread
Ignoring the example trade above, here’s how I’m considering the ratio spread to protect my portfolio. First, instead of selling 1 ATM contract I’m thinking about selling 2 slightly OTM contracts at differing strikes while simultaneously buying 3 further OTM contracts. Here’s a picture that will make more sense.
It’s difficult to see from the payoff diagram here but should SPY move higher at expiration I would actually receive a small profit. However, you’ll also notice the valley of death there in the middle. Should price remain range bound and volatility decline we would experience some amount of loss which could be relatively substantial. That said, what isn’t shown is the low probability that price finishes in that area. In this case, from a probability standpoint, there is only a 15% chance price remains in that valley at expiration.
Finally, the idea here isn’t to profit from the trade if we’re wrong, only to protect us if were right without losing our shirt every time we are actually wrong. I’m not sure if that’s possible but I’m fully testing this strategy for now to see what may be possible.
Protection Amount
Of course, this will differ wildly for everyone based on their level of bearishness or portfolio size. For me, I would probably opt to protect about half of my portfolio loss assumption. Not a hard and fast rule, just a preference to minimize losses if I’m wrong and create enough bang for protection if I’m right.
I’d want to determine how bad I thought the damage would be to my portfolio. Do I think during this bearish decline is a smaller $1k loss or something considerably larger around $10K. Keeping in mind that in the case of a full on melt down, I do have unlimited profit potential. My goal is to minimize buying power usage, create the spread for a credit or a very small debit, and seek to exit the spread as soon as I felt safe to do so. Afterall, we must remember, a hedge is not a portfolio driver. There wouldn’t be any good reason to maintain the position or attempt to profit from it. It’s solely there to protect, at least that’s my sentiment anyway.
Closing Thoughts
Is the options ratio spread the perfect play? No, of course not, there is no such thing. However, it does create the opportunity to protect against a sharp bearish decline while simultaneously limiting portfolio drag. This is the win. Should the market continue marching higher for another 10 years, the amount of put premiums lost will be staggering. Finding a balance that limits that lost “insurance” premium is of the utmost importance.
God bless,
Jeff
