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BACK TO BASICS: Profiting from Ratio Calendar Spreads

By Jeff Neal, Optionetics.com | Mon January 26, 2004 6:45AM PT

When selecting a strategy that can accommodate a consolidating or even a breakout in a particular direction, the ratio calendar spread often times foots the bill. The key advantage of these types of spreads is that they profit from either consolidation or trending price behavior, only suffering a loss if the stock sharply breaks down in the opposite direction of our bias. And even then, provided it hasn’t been a drastic drop, if the strategy is selected with enough adjusting months in between there is time to keep lowering risk each period by selling additional premium.

To get a better handle on this strategy, let’s see how the spread is constructed and walk through a typical application of this trade. Keep in mind that the position can be put on to handle either a bullish or bearish breakout possibility. First, let’s consider applying calls to implement this strategy anticipating a slightly bullish scenario. To construct the spread, the trader would purchase a greater number of back month calls than they sold in the front month.

For example, consider the following call ratio calendar spread for Intel (INTC) where we sell 6 March 32.5 calls and at the same time buy 9 July 32.5 calls. Figure 1, below, lists the actual trade with its associated risk graph. For call ratio calendar spread you are looking for a market where you anticipate a steady rise or some consolidation with not much chance of a downside breakout. From the risk graph you can see the wide profit zone this strategy affords. The trader can profit from sideways, slightly down or a breakout to the upside with the maximum risk being equal to the initial net debit, while the maximum reward is unlimited.

Figure 1: Call Ratio Calendar Spread, INTC
Source: Optionetics.com Platinum

And as mentioned, you can afford a slightly downward movement and you can continue to lower your risk exposure on the trade while at the same time still providing a wide profit zone. Given the adjustment capabilities, the fact that time works for you, and unlike a regular call calendar spread, you can still be in your profit zone even with an upside move provides you with a great strategy to employ in a slightly bullish to consolidating market that allows you enough time to be right.  Another key is that margin required is usually just the net debit versus say a diagonal calendar spread where the margin requirements would be set at a higher level.  

The put calendar ratio spread is constructed the same way only now you would be utilizing puts versus calls. To illustrate consider the flip side of our Intel example where we would sell 6 march 32.5 puts and simultaneously buy 9 July 32.5 puts. Just be aware that some brokers may require you to put the order in as 6 x 6 calendar spread and then legging into the other 3 positions separately. Of course for the put ratio calendar scenario you are forecasting a market to decline or consolidate with little chance of an upside breakout. Again remember in this strategy just as with using calls you still have protection if it goes slightly against your initial bias and gives the trader an opportunity to lower their original risk by selling another month of premium allowing time for the trade to come to fruition.

Both the call calendar and put calendar ratio spreads are great low risk high probability trades that also provide the options strategist with virtually unlimited profit potential making the risk to reward ratio quite attractive. Paper trade and get comfortable with their risk profiles. By doing so, I am sure you will quickly find a way to integrate them into your overall options trading approach.

Happy Trading.

Jeff Neal
Staff Writer & Options Strategist
Optionetics.com ~ Your Options Education Site

Recent articles by Jeff Neal, Optionetics.com

July 22, 2010  -  Morning Watch, July 22
December 29, 2009  -  Dissecting the Basic Stock Quote Page
December 29, 2009  -  Back to Basics: Reviewing the Market Entry and Exit Orders
June 12, 2009  -  Interview Central: Mark Seleznov, Part III
June 05, 2009  -  Interview Central: Mark Seleznov, Part II


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