Planning and Implementing a Ratio Put Spread


We will assume that the trade above could have been executed at a credit of $100, or at worse even-money. “Even-money” simply means that the trader is collecting the same amount of premium for the short options as is being paid out for the long option. In other words, from a cash outlay standpoint the trade is free. Should the spread be executed as a credit of $100 as expected, the position is better than free in that if it expires worthless the trader still gets to keep the initial $100 in premium collected. Keep in mind that a free trade, or one that provides a credit to the trader, doesn't imply without risk of loss or margin.


This trade involves a long put and two short puts; thus, it faces theoretically unlimited risk beyond the reverse breakeven point. Likewise, the exposure of the short puts creates limited profit potential in that gains on the long put will eventually be offset by losses in the two short puts should the market decline substantially. In this instance, the profit is limited to a handsome sum of $3,600; calculated by multiplying the distance between the long put and the short put by the multiplier for the contract ($50) and adding a credit of $100 ((2050.00 – 1980.00) + 2.00) x $50 = $3,600)).


The simplest way to explain the payout diagram of this trade is based on the potential payout at expiration. Upon expiration of this spread, and assuming a fill of a 2.00 point credit, it will be profitable with the futures price trading anywhere from 2052.00 to 1908 without regard to transaction costs. In essence, the spread makes money as from 2050.00 down to 1980.00. If the e-mini S&P 500 futures price at option expiration is at 1980.00 the option spread trader reaps the maximum profit of $72.00, or $3,600.


If the futures price is below 1980.00 at option expiration, the trade is giving back profits until it runs out of money near 1908.00; this level is known as the reverse break-even point. As the futures price drops below 1980.00, the trader faces theoretically unlimited risk. Such a scenario is similar to being long a futures contract from 1908.00. For every point that the futures price moves below the reverse breakeven point, the trader loses $50. I would like to point out that there is only one way for this trade to be a loser at expiration and that is if the futures market is trading beneath 1908.00, which is 142 points beneath the price of the e-mini S&P 500 futures at the time the trade was initiated. To reiterate, ignoring transaction costs, at any point above 1908 through infinity, the trade is either breaking-even or profitable.

 

 

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