Tuesday, May 31, 2011

Options 101: The 1x2 Ratio Call Spread (front spread)

A ratio 1x2 call spread, or front spread, is comprised of 2 legs, both calls at two different strike prices in the same expiration month. Ratio spreads involve buying one option and selling two options with a higher strike price. The most common ratio is 1x2, but any ratio can be used. Ratio spreads can be executed for debits, credits, or even money. Ratio spreads can be very complex, which increases the amount of risk involved.

Generally, a ratio spread profits more from an increase in the underlying stock. Although one of the short calls is covered by the long call, the spread is still short more calls than long. Therefore, the spread has essentially unlimited risk to the upside. Also, ratio spreads generally want implied volatility to go down because the value of the short options will decrease more than the long options.

The maximum value of a front spread is usually achieved when it’s close to expiration. Therefore, most traders use ratio spreads using a shorter time frame. Since ratio spreads are net short option contracts, the passage of time generally helps. The decrease in value of the short options generally is greater than the decrease in value of the long options. 

Similar to the back spread, the ratio spread is one option away from being a butterfly. Knowing the characteristics of both spreads can be the difference between a winning and losing trade.

The graph above is an example of a Ford June $15/$16 1x2 ratio spread. This ratio spread is executed for a debit of $.09. As you can see, the max profit potential occurs at an underlying stock level of $16, the higher strike price. However, the max risk is unlimited because of the short calls.

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