By: Steve Smith
A ratio spread involves buying a higher strike put and selling a greater number of lower, further out-of-the-money puts. For example: buy 1 August 275 put and sell 2 August 260 puts for even money.
The advantages: Ratio spreads can be established for little or no cost. Sometimes, you’ll even see a credit in times of high implied volatility. This means there is no loss if SPY is above $275 at expiration. The position benefits from both time decay and a decline in implied volatility.
The Disadvantages: Because you are selling more put option contracts than you are purchasing it has a “naked” component. Meaning you’re exposed to unlimited losses if SPY shares decline below the breakeven point. In the example above, the breakeven is $260 or a 10% decline in the SPY.
A butterfly spread involves three strike prices in which you buy the highest and lowest and sell twice as many of the middle strike, giving it a 1x2x1 construction. For example: buy 1 August $275 put, sell 2 August 260 puts, buy 1 August 245 put for a $1.20 net debit.
The advantages: Butterfly, which are two offsetting spreads, greatly reduce the cost and risk. They neutralize the impact of time decay and changes in implied volatility. It offers very attractive risk/reward. In this example for a $1.20 risk the maximum profit could be $13.80 or over 900%.
The Disadvantages: The main drawback is the maximum profit can only be realized if SPY is exactly at the middle strike, $260 in this case, at the expiration date. One can only realize very minimal profits prior to the expiration.
These are four examples of how put options trading strategies can be used to both protect against and profit from market declines. The approach you use will depend on your market outlook and risk tolerance.
Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.
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