Hoping in Jesus means not having to worry about the worst. With Jesus, the worst possible scenario turns into the best possible outcome and that isn’t true for anyone or anything else. So today, believe in Jesus, the worst is really the best yet to come!
As traders, if we’re being completely honest, we are always worried about a sharp move against a position. The market has a way of behaving just slowly enough for just long enough that we get over positioned in one way or another. We feel confident and are positioned to capitalize handsomely but then in a matter of minutes everything comes undone.
This leaves me really asking, why do we do this? Wouldn’t we be happier doing something else with our time? Anything else with our time?
However, the flip side to that perspective is that the stock market is, in my opinion, still the single easiest way for average folks to build their wealth. It doesn’t take much time to invest an in S&P index fund or trade a few options strategies. Outside of a few mouse clicks, the work is minimal and people generally love that. So, we brave the waters with hope the next market crash is years away and our money is safe.
The truth though, our money isn’t safe, it never was safe, and it never will be safe. So, in today’s post I want to introduce everyone to the ratio spread hedge options strategy, again. I’ve talked about the strategy before but today I want to elaborate further and share my recent experience. If you’re interested in that previous post here is a quick link to that post, “Investment Portfolio Protection using Options”.
Post Agenda
- The Ratio Spread Hedge
- Risk to Reward and Adjustability
- Personal experience with the ratio spread hedge strategy
Ratio Spread Hedge
The ratio spread hedge, simply stated, is an uneven number of long and short contracts. There could be any number of contracts combined; 1:2, 1:3, 2:5, 50:100, etc. Whatever number of short to long or long to short you could dream up would technically be a ratio spread. However, I’m usually focused on a 3:5 short to long ratio spread using the Micro E-Mini Futures or /MES. The strategy could just as easily be employed on SPY or SPX but the buying power usage for futures is considerably less so that’s my preference.
For an introduction to the put ratio back spread have a look at this article from Investopedia.com. That will offer a basic view of the concept for you to review further.
The key concept when using a ratio spread hedge as a tool for protecting a portfolio is in the trades structure. I always want to maintain more long puts than short puts so if the market declines more contracts are gaining value than losing value. The key benefit to using the ratio spread as opposed to a simple long put is the offsetting credit received from selling the short contracts.
An example trade would look like this. I would sell 3 contracts at a strike of $4400 and buy 5 contracts at a strike of $4350. That trade would have a max profit potential of $42,651 and a max loss of $850. Additionally, the trade can easily be managed to remove the short contracts risk after some or most of the short premium has decayed away.
Risk to Reward and Adjustability
These key features make the trade stand out against just buying a long put. Sure, many prefer the simplicity of just buying puts outright in case the market craters but that can get expensive. The short contracts provide a credit to offset the long cost. Leaving much of the same protection at a lesser cost.
For example, if I we’re to use SPY and buy a long put with 117 days to expiration at a 10 delta the trade details would look as follows;
- Long Cost – $374
- Max Profit – $48,126
- Max Loss – $374
Similarly, if I we’re to construct an equal position using the ratio spread hedge my metrics would be;
- Ratio Spread Cost – $320
- Max Profit – $47,180
- Max Loss – $820
Not significantly less, I’ll admit, but place this trade 3-4 times a year for several years and the $54 dollar difference really adds up. Now, you’re probably saying, ok, but what about that max loss? I agree, the max loss is considerably more but that only occurs if at expiration the price of spy pins the long strike. If price falls to the long strike at any time before the final day or two, the trade is profitable. Any fall beyond the long strike and the trade is wildly profitable.
To make things a little easier, here are a couple of images of that trade at different stages and in the final image a look at what volatility would do.
In the first image above you’ll notice that a 10% decline in the price of SPY would result in about a $900 profit. That same decline after 2 months would still result in about $400 dollars of profit. As seen from the second image. In the final image, after 2 months you can see what an increase in volatility would do as well. A 10% decline coupled with an increase in volatility would result in a profit somewhere between $400 and $5,000!
Adjustability
The second prominent feature of this strategy is with regard to adjustment. I’m not an advocate for making my hedge another risk. However, if completed properly and monitored closely the ratio spread hedge could also be an income producing strategy. All while maintaining the massive downside hedge. Let me explain.
First, remember earlier I suggested closing short contracts when most of their value is gone. Let’s say I decide to close the short contracts when their value is $1. Using the example SPY trade above, if the market went absolutely no where I could close those short contracts with 40 days remaining on my long contracts. Essentially opening the door for a ratio spread diagonal hedge. Sounds complex I know but consider what I’m doing. I’m simply “re-using” the longs to generate more premium decay.
In theory, it works perfect but theory and reality are always starkly different so DO NOT try this if you’re not entirely confident in your ability as an options trader. However, if you’ve been trading for some time you’ll quickly notice this offers you 40 days worth of premium decay on your new short options before having to roll your longs to keep the downside hedge in place.
Here is an image to highlight what I’m saying, hopefully that helps clarify a little further.
Notice that the trade structure is very similar. The downside protection would remain intact as long as the longs had time remaining. Only now the upside would also yield a profit.
Lastly, in this example I only opened 1 new short to keep the 1:2 ratio I had been working with. There wouldn’t be anything stopping us from just opening some new combination of longs to shorts. So long as more long puts exist to short calls the downside will remain protected.
Personal Experience
Before I close, I wanted to share what happened to this trade during the volatility spike earlier this month. As mentioned above, I prefer the /MES ratio spread hedge position consisting of 3 shorts to 5 longs. I paid $58 dollars to enter the trade and when price fell in mid July the trade quickly became profitable.
The trade was up about $150 and I locked in a profit. I bought to close 1 short and sold to close 2 longs. This left me with a lesser ratio spread but my downside was still protected by the 2:3 ratio spread hedge. Closing that portion of the ratio spread locked in a $70 profit and the trade cost was covered.
A few days later volatility also ramped up and the smaller 2:3 ratio spread hedge skyrocketed in value to at one point near $1000. I just happened to log in and see it near $1,000 at some point. Honestly, I should have closed it then but I wanted to keep the hedge. In the next 2 days the trade shrank back to now only about $25 of value.
Still, all things considered, a free trade was more than protecting my portfolio and that’s exactly what I need. The trade has about 83 days remaining so I may still be able to adjust it as mentioned above.
Until the next post.
God bless,
Jeff
