Jitendra Panda, Business Head-Broking, Capital First explain that ratio spreads are nothing but an extension of a vertical spread and here the investor basically has to take a view whether it is bullish or bearish. He further elucidates the difference between the bull spread and a ratio spread.
Below is the verbatim transcript of his interview to CNBC-TV18
Q: If we start with ratio spreads what kind of psychological profile or sentiment of the investor do they answer to?
A: Ratio spreads are nothing but an extension of a vertical spread. Here the investor basically has to take a view whether it is bullish or bearish. If he is bullish then he can take a bull spread, but then here is using ratio. What is the difference between a bull spread and a ratio spread? In a bull spread you are buying at-the-money (ATM) or in-the-money (ITM) Call option and selling a higher Call option. For 1:1 it is called a bull spread plain vanilla.
However, if you are buying one Call option and selling two Call option out-of-the-money (OTM) then it is called a 1:2 ratio spread. This ratio can be 1:2, 1:3 based on the risk appetite. So the ratio spreads are done to gain near the premiums.
Since you are selling two OTM Call options you get twice the money in and so your outflow is very low for buying the Call options. The advantage is your payout is very low, but that advantage comes with a higher risk.
Q: Can you give us example of how much money could you possibly lose if your ratio spread does not work as you have perceived it?
A: Let us take an example of Tata Steel. For our example the price is at Rs 300 in the stock market. So ATM option is Rs 300. I buy a Call option of ATM and if it cost me for example, Rs 10. In a ratio spread I will try to sell OTM Call option.
For example, I believe it is moderately bullish I will go and sell two Call options of Rs 320. Each option is at Rs 4 there, so when I sell two Call options I get Rs 8, Rs 4 each for the option, so my inflow comes Rs 8, my outflow was Rs 10, so the net cost to me is only Rs 2.
So, I have bought a Rs 300 Call option of TISCO in a bull ratio spread with Rs 2. So anything above Rs 302 which is my breakeven point, the strike price plus the outflow, the risk if TISCO explodes, suddenly there is some event and it moves above Rs 320. My risk can go to unlimited the higher it goes, because I have to pay because I have sold two Call options. So the risk is unlimited if it explodes above Rs 320, but if it remains within Rs 320 I make Rs 18 profit.
Q: Your cost Rs 302 because of the premium that you have brought in which was about Rs 8. Beyond Rs 320 that is where you start to make losses. How do you decide that within this Rs 18 range when do you book your profits?
A: If you go through the books they will say at Rs 320 you selloff. But practically when you see Rs 302 we have seen that people exit at Rs 310-315 range, depending on the risk appetite. As you move ahead the option premium of Rs 320 will move faster, so your losses will start increasing. So you need not wait for that.
So Rs 310-315 range is where you need to exit and make your gains. For Rs 2 you will have maybe Rs 5-6 profit after paying out all the Rs 320. So you will make three times of your money in a month and that is fair enough. They say you control your greed in this market. This is all about greed and fear and we have read and we have learned so much, now let us put in practice.
Q: How do you manage factors like time value, the volatility on a counter like this?
A: Spreads always have this advantage. The time value comes up and that is what you are doing. When you are in a ratio spread, when you are buying one Call option you are paying some time value, but when you are selling two options of the outside you are in fact gaining the time value, because those options have time value which you are taking in. So you are gaining those time values, because you are selling Rs 320 Call options of Tata Steel.
So ratio spread gives advantage that if you feel that Rs 320 is a major resistance level and may not crossover the markets, ratio spreads are most popular at those times. When you know that those are critical levels on valuations fronts or on technical fronts or within the timeframe available for the option, you feel that Rs 320 is a very stretched target options available. You sell them and you have risk in your hand and some risk you have to pay.
Q: How popular are Put ratio spreads? When you use such a strategy?
A: Since ratio spreads give you very low cost and an advantage, because your breakeven points are very closer to the options which you have bought, because you sold in case of a bearish spread Put options. In case of a bear spread, it is very difficult to be bearish in the market and play the market.
However, bear Put spread, when you buy ATM Put option and sell two or more higher OTM Put options you gain. You gain the benefit that market moves little down also and when they fall they have that advantage of taking it. But I would like to warn you, based on markets, when the market goes up they go slowly and steadily, but then they fall they fall like a ping-pong ball. Doing a ratio spread on Put side, the bearish ratio spread, you have to be very cautious.
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