Forecasting and options spreads

07/07/22
  • There’s no such thing as a neutral options strategy
  • Ratio spread: long and short options, targeted forecast
  • Strategy may not be appropriate if volatility is anticipated

Price-neutral options strategies are sometimes discussed in terms of liberating traders from having to forecast the market. For example, buy an at-the-money (ATM) call option and an ATM put option (a long straddle), and if the underlying market moves far enough in either direction, the position can turn a profit. No forecasting required!

Not quite, since this type of strategy simply replaces a price forecast with a volatility forecast: Price must move enough—i.e., volatility must increase enough—to offset the cost of the options.

Making sure a trade strategy complements a forecast sounds easy, but it can become increasingly difficult when combining long and short options in spreads. For example, for most of this year Visa (V) has moved mostly sideways, swinging in a wide range (roughly $186 to $235):

Chart 1: Visa (V), 12/13/21–6/30/21. Visa (V) price chart. Up-and-down trading.

Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)


Let’s say a trader expected the stock to move mostly sideways in the near future, but more to the upside than the downside. One strategy that is sometimes considered in this type of situation is the call “ratio spread,” which combines (in its simplest form) a long ATM call with two short higher-strike calls. Here’s what its risk-reward profile looks like:

Chart 2: 2:1 ratio call spread risk-reward profile. Options spread strategy profile. Unlimited risk if stock rallies.

Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)


First, notice the strategy is a modified bull call spread, which is a limited-risk, limited-reward strategy some traders use when they expect a modest upside move in the underlying stock. The 2:1 ratio spread simply contains two OTM short calls instead of one.

But what a difference that extra short option makes. Like the bull call spread, the ratio spread’s risk is limited to the net cost of the options no matter how far the stock falls, but its risk is unlimited if the stock keeps rallying. The second short call doesn’t have a long call to offset its losses, so it continues to lose money as the stock rises.

If the forecast was instead for the stock to have a mild downside bias, the trader might invert the 2:1 ratio spread by purchasing an ATM put and selling two OTM (lower-strike) puts. In this case, the risk is limited to the upside but unlimited to the downside:

Chart 3: 2:1 ratio put spread risk-reward profile. Options spread strategy profile. Unlimited risk  if stock falls.

Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)


Both call and put versions of the ratio spread may appear to be suited to situations where the trader doesn’t have a strong option about price direction, but in reality, the strategy’s potential profitability is based on a very specific forecast: That price will move in a certain direction—but not too much—over the life of the trade. In other words, it’s not a strategy designed to handle volatility surges.

A trader with confidence in such a focused forecast may choose to use a strategy like the ratio spread, but as this year has shown, it’s impossible to know when the market or an individual stock will make an unexpected big move.

There’s no getting around forecasting. Sometimes the first step toward finding a strategy that best reflects a forecast is to weed out the ones that don’t.

Today’s numbers include (all times ET): Challenger Job Cuts Report (7:30 a.m.), ADP Employment Change Report (8:15 a.m.), Foreign Trade Balance (8:30 a.m.).

Today’s earnings include: WD-40 (WDFC), Levi Strauss (LEVI), PriceSmart (PSMT).

 

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