thinkMoney - Summer 2018

you’re good to go. Both the options would expire O TM and worthless, and you’d keep the $0.55 credit as profit.

On the other hand, if the stock drops below $165 prior to or at expiration, then the trade could start to gain value. The trade would hit its breakeven price with the stock at $164.45 ($0.55 below the $165 strike), and your spread would hit the maximum loss if the stock drops to $160 or below. At that point the vertical spread you sold for $0.55 would now be worth its maximum value of $5, handing you a loss of $4.45. While this outcome may be unlikely, be prepared. Of course, you can always attempt to close your trade prior to expiration if the market isn’t moving as you expected.

Call Ratio Backspread

Experiment with this strategy if you
think the market is moving signifi-
cantly higher or pulling back considerably—
none of this “in-between” stuff, because a
move that’s only moderately higher could be
a problem closer to expiration. That’s why
many traders engage the call ratio back-
spread strategy with options further out in
time, say, 90 days or longer.

This approach consists of a short O TM call that’s closer to the money and has twice as many long calls at a higher strike. The idea is to create a trade whose entry price is preferably a credit. But the trade can also be placed for “even money” or a small debit. In short, if the market drops, there’s no harm, because all the options expire worthless. And if the market rips higher, the profit from the two long calls outpaces the loss of the short call.

As an example (Figure 3), say the underlying is trading at $179. You could sell the $185 call for $4.50 and buy two 195 calls for $2.19 each, or $4.38. With these prices, the net cost comes to a credit of $0.12 ($4.50– $5.05), plus transaction costs. But the risk of the trade is the difference between the strikes, less the entry credit (or, plus the entry debit). In this case, it’d be $9.88.

Where’s the risk? If the stock runs
through the short strike of $185, but stops
at the long strike of $195, the short $185 call
loses $10 without the $195 calls pitching in
any help. Knocking off the entry credit of
$0.12 leaves you with the maximum loss of
$9.88 if the stock sits at $195 at expiration.
When trading this strategy, some opt to look
at options further out in time and close the
trade perhaps 30 days before expiration if
the stock is anywhere near either strike.
With plenty of time left until expiration,
if the stock moves high enough, the profits
from the two long options can start to out-
pace the losses from the one short option.
So, even though the $195 call will have a
smaller delta compared to the $185 call, be-
cause there are two of them, the trade’s net
delta could be positive. From another angle,
the losses from the $185 call are offset by the
$195 call, except for the $10 difference be-
tween the two. That leaves the second $195
call free to profit without a cap.
Likewise, if the underlying stock moves
lower, and the spread moves further O TM,
then all the option prices move toward
zero. Because you initiated the trade for
a credit, if the options expire worthless,
you’d actually make a little profit, less
transaction costs, despite being wrong on
the direction of the stock.

EACH OF THESE UNIQUE STRATEGIES has defined risk and relatively small capital requirements. But they also offer a chance for profit and greater flexibility depending on your perception of a rally or a bounce. Keep your head when markets can’t make up their minds—or when the tantalizing branches at the tops of majestic sequoias call to you.

Kevin Lund is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc. For more on the risks of trading and trading options, see page 37, #1– 2.

FIGURE 2: Short put vertical spread. From the Trade tab, enter a symbol and view the option chain of the puts. Source: thinkorswim® from TD Ameritrade. For illustrative purposes only.

FIGURE 3: Call ratio backspread. From the option chain on your thinkorswim platform, consider calls that are further out in expiration. Source: thinkorswim® from TD Ameritrade. For illustrative purposes only.