Definition Of Ratio Table In Math latest 2023

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Convert a Collar Trade Into Ratio Backspread

There are three potential scenarios for the collar position here: we can hold it until expiration, we can exit the trade once our target price has been reached, or we can convert it. In the previous example, we converted the collar trade into a bull call spread. In this example, we will convert the collar to a ratio spread, also known as a call backspread.

A standard definition of a ratio spread can be found on Investopedia as “an options strategy in which an investor simultaneously holds an unequal number of long and short positions. A commonly used ratio is two short options for every option purchased” . Therefore, depending on who you talk to, by buying more options than you are selling, you are essentially in what is called a call backspread or a ratio backspread.

The main difference is that a standard ratio spread exposes you to unlimited risk because you have an extra short position, while a ratio backspread exposes you to unlimited profit potential because you have a very long position. Regardless of the technicality of the name, selling one option and buying two options is less risky than buying one option and selling two options. Therefore, you always want to do the former, not the latter, if your goal is to manage your risk.

hold it

In the example in Table 1, all indicators point to a short sale in the corn market. Placing a protective call at $5.10 shields the position from any sudden upward moves. The call costs $1,000. To offset the costs of the call option, a put can be sold at a support point, $4.30. The sold put earns $250 in premium.

Table 1: Maintaining the classic corn neck

Short Futures Buy Protection Sell Put for

Call/premium/bonus income

Collection

Admission $5.10 $5.10 (-$1,000) $4.30 (+$250)

Exit $4.30 $4.30 (-$1,000) $4.30 (-$250)

Simply holding the trade until it expires results in a $1,000 deduction from profits. The call option expires worthless, leaving $3,000 in profit. The sold put must reach $4.25 before it can be considered profitable (determined by subtracting the strike price from the premium collected), and even if it reaches this low level, the short position in the futures contract may end up covering your losses. A mere profit of $3,000 can be made if the deal goes off without fanfare.

Risk

The risk for this collar is no different from the risk associated with the first example. Holding a collar until expiration exposes the position to multiple price increases and decreases as the market fluctuates. This happens without the guarantee that the underlying futures position will actually reach the resistance level where the put option was sold. Any lack of momentum on the part of the underlying futures contract will lessen the impact of the sold put option. By itself, the sold option cannot produce a significant revenue stream to cover the call option that was purchased, nor will it compensate for the disappointing results of the futures contract. This leaves the trader with the maximum possibility of earning $3,000 while leaving the trader open to earning much less.

Go away

If the market is moving in the right direction but you don’t want to hold the trade until it expires, the trade can be liquidated early. When we look at Chart 2, we can see that the market has reached the $4.30 level, but it just cannot break through the $4.10 level. Tremendous support has built up in the $4.30-$4.10 range with the possibility of the market turning around and rising at any moment.

With the threat of this happening, it may be best to exit the trade without waiting for expiry.

Table 2: Classic Corn Collar Clearance

Short Futures Buy Protection Sell Put for

Call/premium/bonus income

Collection

Admission $5.10 $5.10 (-$1,000) $4.30 (+$250)

Exit $4.30 $4.30 (+$150) $4.30 (-$700)

Profit/loss +$4,000 -$850 -$450

Risk

Exiting the trade before expiry results in two additional costs associated with the trade, both of which will lower profits. First, by leaving the protection call, you will be penalized. Although you won’t lose your entire $1,000 call bonus, it is possible that it will. In this example, you end up losing $850.

The same problem arises for the sold put. The put option must be repurchased at the prevailing market rate. You initially received a premium of $250, but now you have to pay $700 to exit the position, so your put loses $450. This gives your corn position a total loss of $1,300 against a profit of $4,000. This leaves the corn position with a net profit of $2,700.

Convert it

The decision to put a ratio spread can be difficult. There may be a feeling that the market will continue to fall, but you don’t want to expose your profits to setbacks, or shut yourself out of future short-term profits just because you sold a put option.

This is where the ratio gap comes into play. If we look at Chart 3, we can see the nascent beginnings of converting from a necklace to a ratio gap.

Since there is a new support zone developing around the $4.10 level, we decide to take some of the profit and reinvest it into buying two put options. The intention is to lock in all of our profits on the short futures in our account, while avoiding a loss on the put option we sold.

By holding the short futures position until it reaches $4.10, we free up an additional thousand dollars, bringing our total futures to $5,000. By doing so, we ensure that all potential losses incurred by the put option we have written are covered between $4.30 and $4.10. It also gives us a bit more capital to buy the two put options at $4.10.

A put option continues to hedge the put option we sold, lowering our unlimited risk and allowing us to exit our futures position. The second put is our moneymaker. For $900, we get to free up our account equity by eliminating corn margin requirements, while participating in the price drop and any potential chance to collect the premium.

Table: Convert Classic Corn Collar to Backspread Ratio

Short Futures Exit Call Sell Put/Premium Buy Two Puts to Continue Short

Admission $5.10 $5.10 (-$1,000) $4.30 (+$250) $4.10 ($450/each or $900)

Exit $4.10 $4.30 (-$1,000) $3.70 (-$2,400) $3.70 ($2,000/each or $4,000)

Profit/loss +$5,000 -$1,000 -$2,150 +$3,100

In Chart 3, we see the fully exited trade: no call, no put, sold or bought. The time it takes to get there is almost four months. It’s definitely an exchange of position.

Risk

There are a number of downsides to going from the collar to this type of ratio gap. The first issue is the number of variables you have to deal with before the final execution of the short-term trade. If you keep the futures position short for too long, the market has a chance to bounce back on you and take back your profits.

A second problem arises when buying the two additional put options. Although they are slightly out of play, they have the ability to be quite expensive compared to the premium you received on the put option. In fact, the expense can far outweigh the benefits of continuing to trade.

Finally, a trade that originally only took 26 days to generate profits now takes 103 days before you receive all your money, and all the while you don’t know if the trade will work. That’s almost a quadrupling of your trading period with little guarantee that the market will continue to decline. If the market were to move against your two put options, you would lose the $1,100 premium. This risk may not be worth it. That’s why it’s important to do your math before executing a trade like this.

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