Ratio Put Write : Take Advantage Of Low Volatility

Introduction To Ratio Put Write Option Strategy

Ratio Put Write

The ratio put write is an options trading strategy that involves the shorting of the underlying security and put options derived from it. This strategy has unlimited risk to the upside and downside and a limited profit potential.

Net credit

Execution of a ratio put write strategy results in a net credit received from shorting the put options. For the purposes of clarification, the proceeds from the shorting of the underlying security does not make up the net credit received.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Little Volatility
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Unlimited potential losses
Step 7 : Loss calculation on ratio put write
Step 8 : Limited profit potential
Step 9 : Maximum profit calculation of ratio put write
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade – Executing a ratio put write strategy
Step 12 : Exit The Trade & Record Trade In Diary

 

Step 1 : Perform economic, fundamental and technical analysis

Examine impending events related to the economy or the  underlying security that may cause volatility to increase. Technical analysis may help a trader to determine breakouts in price. Some chart patterns to look out for are:

Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis

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Step 2 : Outlook – Little Volatility

The options trader who executes the ratio put write strategy that has an inverted “V” risk and reward profile. This means that he anticipates little to no volatility in the price of the underlying security. When that happens, the trader stands a chance of attaining the maximum but limited profit. Of course, a brief glance at the risk and reward profile will tell traders one thing: the maximum profit is attainable at only one price point in the underlying security. This is a point of consideration when using the ratio put write strategy.

If the price of the underlying security rises slightly above the strike(exercise) price of the put options, the put options will expire worthless. The options trader can profit from the short sale of the underlying security if the price reverses after the expiration date of the options.

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Step 3 :Study the option chain

Examine the options chain. Select the options to be used in the ratio put  write. After this has been done, breakeven analysis can be performed.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

It is important to perform breakeven analysis after the options have been selected. An options trader can use the formulas shown below.

Upside breakeven point = Exercise price of shorted puts + Credit received

Downside breakeven point = Exercise price of shorted puts – Credit received

If the credit received from the shorting of puts if $500 and the strike price of the puts is $50, the upside breakeven point is : $50 + $5 = $55.

The downside breakeven is : $50 – $5 = $45

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Step 5: Understand Your Profit Zones

RatioPut Write

After performing breakeven analysis, the options trader will understand where the profit zones are. The  profit zone is any  price point between the upside and the downside breakeven points.

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Step 6 : Unlimited potential losses

In a ratio put write option trading strategy, the losses are potentially unlimited. If there is a significant price increase in the underlying security, there exists the possibility of an unwanted and very significant loss. To the downside, since the price of the underlying security can theoretically go down to 0, the loss are limited but can be substantial.

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Step 7 : Loss calculation on ratio put write

When the price of the underlying security trades below the downside breakeven point, a loss is incurred. If the price of the underlying security trades above the upside breakeven point, a loss is also incurred.

When the price of the underlying security trades below the downside breakeven point, a loss is incurred. If the price of the underlying security trades above the upside breakeven point, a loss is also incurred.

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Step 8 : Limited profit potential

There is a limited profit potential using the ratio put write strategy.

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Step 9 : Maximum profit calculation of ratio put write

The maximum profit is limited to the net premium received by writing the put options less any brokerages fees paid to initiate the trade. The maximum profit is limited to the net premium received by writing the put options less any brokerages fees paid to initiate the trade. The maximum profit can be calculated as:

Net credit – brokerage fees paid

The maximum profit is achieved at the exercise or strike price of the put options.

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Step 10 : Calculate Risk & Reward Ratio

If stop losses are put in place, a trader is able to calculate the risk and reward ratio. Going through this procedure is important because it determines the attractiveness of a trade on a risk and reward basis. Imagine Trade A with a potential risk and reward ratio of $1 of risk to $5 of reward versus Trade B with a potential risk and reward ratio of $1 of risk to $2 of reward. Certainly, the risk and reward ratio of Trade A is more attractive.

Read more : Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Set Up Trade – Executing a ratio put write strategy

For every 100 shares shorted by the options trader, he can simultaneously write 2 at-the-money put option contracts to create the inverted V risk and reward profile of the ratio put write strategy. The 2 put option contracts have an underlying exposure to 200 shares.  This is typical of a ratio put write strategy.

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Step 12 : Exit The Trade & Record Trade In Diary

After the trade has been exited, the trader should make an effort to record the trade in a diary or a journal. The results and performance of this trade should be compared to other trades. Also the trader should make an effort to examine the whole trade execution process. Over time, this can help a trader to become better.

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Example Of A Ratio Put  Write

The price of XYX Corp currently trades at a price of $50. An options trader anticipates low impending volatility. he executes a ratio put write by shorting 100 shares at $50 and shorting 2 ATM put option contracts at a $2.50 each.

The net credit is thus:

$2.50 x 2 x 100 = $500

The upside breakeven point is:

$50 + $5 = $55

The downside breakeven point is:

$50 – $5 = $45

If the price of the underlying security trades at levels above the upside breakeven or below the downside breakeven, the ratio put write trade will incur a loss if it is closed out.

Let us examine the scenario where the price of XYZ trades at $50 on expiration of the options.

Beginning value End value Profit(+) or Loss(-)
Short 100 shares $50 $50 No profit or loss
Short 2 ATM puts $2.50 each $0 + $2.50 each

The put options will expire worthless and the net credit is kept by the premium. The net credit in this case is also the maximum profit of:

$2.50 x 2 x 100 = $500

Since the maximum profit is capped, it would make sense that the option trader tries to maximise the net credit received.

Comparable strategies

A very similar strategy is the ratio call write strategy. Both the ratio call write and ratio put write strategies capitalise on low volatility in the underlying security.

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