In today’s report we shall focus on how retail clients can design ratio spreads. We shall also look into the objectives of a ratio trader. First let us find out what a ratio spread is. In conventional terms, a ratio spread is an option trading methodology in which a trader combines a number of long and short positions and considers it as a single trade. You can think of it as a bouquet which comprises of different flowers but is sold as one single unit.
Two Different Market Types
If you notice closely, markets can be classified under two distinct categories based on the shift in options vega. Either the market can be hit with high volatility or will witness a period of low volatility. To design a profitable ratio, the trader must accurately calculate whether the options implied volatility will rise or is likely to drop. The idea here is to design a spread that fits these two parameters also keeping in mind the time till expiry. It is very similar to shifting gears in an automobile depending on the condition of the road and the speed of the vehicle. If the road is bumpy, the driver slows down the vehicle and the gears are shifted down to induce more thrust and keep the momentum intact.
Ratios For Low Volatility
In practice, retail clients can also design ratios. All they need to do is analyze whether the implied volatility is low or high. During a low volatility phase, front spreads or vertical spreads are effective. In a front spread, more number of options are sold than purchased. This is a ratio which is built when volatility decreases. A front ration spread will generate returns, when the volatility drops. It is similar to the trade we had showcased in our article on 23rd July. The ratio comprised of selling in 2 lots of 11500 Call option and buying in 1 lot of 11400 Call option.
Ratios For High Volatility
In situations when markets are hit with high volatility, retail traders can focus on back spreads. In a back spread, the options trader buys more number of options than he sells. These spreads are designed to generate returns during high volatility or when the IV increases. Implications of this argument are that the spread’s gamma and Vega covariance factors should fall in line to benefit the option combination. Whatever be the case, the implied standard deviation of the sold options in a ratio generally must exceed that of the bought options.