Profit from the right moves, no losses for mistakes—grasp this strategy!

Hello

Welcome to Tiger Academy - 「Options Advanced Strategy」episode 1.

In this series, we will delve into several advanced options strategies to help you transition from a beginner investor to an options expert.

In our previous articles, Tiger academy discovered a common pain point among options traders, especially those on the buy side. Despite the significant leverage, many found that nine out of ten trades resulted in losses. Is there a strategy that allows us to profit when we are right and avoid losses when we are wrong?

Indeed, such a strategy exists, and today we will explore it — the Ratio Spread Strategy.

1. What is the Ratio Spread Strategy?

The Ratio Spread Strategy involves creating an options portfolio with a specific ratio of contracts. In our previous options strategy articles, we introduced various combination strategies, all defaulting to a 1:1 ratio. For example, the straddle strategy combines one call option and one put option, while the bearish/bullish call/put spread strategy uses one low-strike and one high-strike call/put option.

However, there's a drawback to using a 1:1 ratio: It fails to fully hedge the price volatility of the options because the delta values of the two options are not equal, leading to uneven price movements.

For instance, in a bullish call option spread strategy Option Strategy Explanation 02 |How to amplify the return through the option strategy with a current stock price of $100, buying a call option with a strike price of $100 (delta = 0.5) and selling a call option with a strike price of $110 (delta = 0.25) could result in a net loss of $0.25 when the stock price drops by $1. Adjusting the ratio based on delta values, what if we sell two contracts of the $110 strike call option (2 * 0.25/0.5)? In this case, the profit from the sold call options offsets the loss from the bought put option, resulting in a balanced portfolio without fluctuation.

This is the essence of the Ratio Spread Strategy — a strategy that determines the quantity of option contracts based on delta values.

Now, let's address the risk and return of the Ratio Spread Strategy in a nutshell: Make the right moves, earn profits; make mistakes, avoid losses! Don't believe it? Let's run the numbers.

1.Making the Right Moves for Profits and No Losses?

As seen in the previous example, the Ratio Spread Strategy, incorporating quantitative methods, can better hedge against losses resulting from adverse price movements compared to conventional combination strategies. But what about the ultimate returns of the Ratio Spread Strategy when there are favorable price movements?

Continuing with the previous example, if the stock price rises to $101, the bought call option profits by $0.5, while the net loss from the two sold call options is $0.5, offsetting each other and resulting in a stable portfolio return.

In theory (assuming constant delta values), during the holding period, the profits and losses of the Ratio Spread Strategy are fully hedged, whether there are favorable or unfavorable price movements. If that's the case, how does this strategy make money?

There's only one way – by holding the position until expiration, especially when the price remains stable within a range. At expiration, profits are generated based on the exercise perspective. Without considering premium, the call option with a $100 strike price profits by $1 (101-100), and the two sold call options result in a net gain from the premium. This strategy has a high probability of being profitable.

Of course, in practice, even with a theoretically perfect strategy, it might be challenging to achieve success. To illustrate this, let's apply the Ratio Spread Strategy to Tesla's current market conditions.

3. How to Implement the Ratio Spread Strategy with Tesla?

Let's assume that we anticipate $Tesla Motors(TSLA)$ 's stock price to exhibit a moderately strong fluctuation within the range of $235 to $245 before December 1, the next week. In this scenario, we decide to purchase one call option contract with a strike price of $235, incurring a premium cost of $5.6 per contract, and a delta coefficient of 0.549. Additionally, we sell two call option contracts with a strike price of $245, generating a premium income of $3.76 per contract, with a delta coefficient of 0.257.

In the case of a stock price decline by $1, the bought call option with a $235 strike price incurs a loss of $0.549, while the two sold call options with a $245 strike price generate a profit of $0.514 (0.257 * 2). The overall gain and loss are essentially offset.

If the stock price rises by $1, the first scenario results in a profit of $0.549, and the second scenario incurs a loss of $0.514. The combination experiences a slight profit, and the gains and losses are essentially offset.

Given that the combination is based on the expectation of Tesla's stock price fluctuating within the $235 to $245 range, the premium income from selling the two call option contracts, $3.76 per contract, can be reliably obtained. With a premium expenditure of $5.6 for the bought call option contract, the net premium expenditure is $1.84. Therefore, as long as the stock price rises above $236.84 ($235 + $1.84), the combination is profitable.

If the stock price rises above $245, the delta hedging effect of the bought and sold call options prevents losses. However, this is based on the assumption that the delta coefficients remain constant. In reality, if the stock price rises to $245, the delta coefficients of both the bought and sold call options will increase, potentially resulting in minor floating profits or losses.

In summary, within the $236.84 to $245 range, the combination is profitable; outside this range, the combination theoretically does not incur losses.

However, it's important to note that due to non-integer delta values, perfect hedging may not be achieved. Additionally, the presence of net premium expenditure may lead to losses if the stock price does not fall within the ideal range (as seen in the example, $1.84).

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