Bracket Trading Techniques

Ratio spreads are neutral in the sense that you don't want the market to move much either way once you make the trade.

While call and put ratio spreads can be effective strategies when you are expecting relatively stable prices over the short term, they are not without risk. By definition, a ratio spread involves more short than long options. If the trade moves against you, the extra short option(s) expose you to unlimited risk.

Put Ratio Spreads

To create a put ratio spread, you would buy puts at a higher strike and sell a greater number of puts at a lower strike. Ideally, this trade will be initiated for a minimal debit or, if possible, a small credit. This way, if the stock jumps, you won't suffer much because all of the puts will expire worthless. However, if the stock plummets, you have unlimited risk to the downside because you will have sold more options than you bought. For maximum profitability, you want the stock price to stay at the strike price where you are short options.

Using Bubba Gump's stock (XYZ) with a price of $42, we can create a ratio spread using in-the-money options.

Strike Price	Put Price
$60	25.50
$55	20.60
$50	15.75
$45	10.00

In this case, you might buy one 60 put at 25.50 and sell three 45 puts at 10.

Short 3 45 puts @ 10: ($30)
Long 1 60 puts @ 25.50: 25.50

In this case, you would receive a $450 credit for putting on the trade. If the stock jumped above 60, you would keep the $450. However, the real money would be made if the stock stayed right around $45. Here, the short 45 puts would expire worthless and the long 60 put would be worth $15. The value of the 60 put, combined with the initial $450 credit would bring the net profit up to $1,950.

A big move to the downside in this case would spell trouble. The downside breakeven for this trade is $35.25. At this price, the short 45 puts would be worth 29.25 (9.75 x 3) while the long 60 put would be worth 24.75. Factoring in the initial credit of $450, the position would be worth zero. Below $35.25, the risk is unlimited.

Value at Expiration

Strike Price	Profit (Loss)
$25	($2,050)
$30	($1,050)
$35	(50)
$40	$950
$45	$1,950
$50	$1,450
$55	$950
$60	$450

Calculating the Breakeven

The easiest way to calculate the downside breakeven is by using the following formula:

[# of short puts x (short strike - short put price) - # of long puts x (long strike - long put price)]

( # of short puts - # of long puts )

Using the data for this example, the breakeven calculation looks like this:

[3 x (45 - 10) - 1 x (60 - 25.50)] / (3-1)

Simplified, the equation becomes:

(105 - 34.50) / 2 or 35.25

Thus, the downside breakeven is $35.25.

Call Ratio Spreads

Like the put ratio spread, call ratio spreads are great strategies when you are expecting relatively stable prices over the short term. To create this position, you would buy calls at a lower strike price and sell a greater number of calls at a higher strike price. Here again, do your best to initiate the trade for a minimal debit or even a small credit. This way, if the stock drops, you won't suffer much because all of the calls will expire worthless. However, if the stock takes off, you will have unlimited risk to the upside because you will have sold more options than you bought.

Using Bubba Gump's stock (XYZ) at a price of $42, we can create a ratio spread using in-the-money options.

Strike Price	Put Price
$30	15.50
$35	10.60
$40	5.75

In this case, you might buy one of the 30 calls at 15.50 and sell three 40 calls at 5.75.

Short 3 40 calls @ 5.75: ($1725)
Long 1 30 call @ 15.50: $1550

You would receive a $175 credit for putting on the trade. If the stock dropped below 30, you would keep the $175. However, the real money would be made if the stock stayed right around $40. Here, the short 40 calls would expire worthless and the long 30 call would be worth $10. The 30 call, combined with the initial $175 credit would bring the net profit up to $1,225.

A big move to the upside in this case would spell trouble. The upside breakeven for this trade would be $ 45.90. At this price, you'd have to buy the short 40 calls for 17.60 (5.90 x 3). At the same time, you'd sell the long 30 call for 15.90. The $175 debit from this trade would be exactly offset by the $175 credit you received for putting on the trade (not including commissions.)

bove 45.90, your potential loss would be unlimited.

Value at Expiration

Strike Price	Profit (Loss)
$25	$225
$30	$225
$35	$725
$40	$1,225
$45	$225
$50	($775)
$55	($1,775)
$60	($2,775)

Calculating the Breakeven

The easiest way to calculate the downside breakeven is by using the following formula:

[# of short calls x (short strike + short call price) - # of long calls x (long strike + long put price)]

( # of short calls - # of long calls )

Using the data for this example, the breakeven calculation looks like this:

[3 x (40 + 5.75) - 1 x (30 + 15.50)] / (3-1)

Simplified, the equation becomes:

(137.25 - 45.50) / 2 or 45.90

Thus, the downside breakeven is 45.90 or 45.90.