Ratio Spreads

Abstract

Long before the Black-Scholes equation was developed option traders had a lexicon of colorful names for common option positions: butterfly spreads, straddles and strangles, strips and straps, and many more. These terms remain in use, even as risk evaluation for options positions is now expressed primarily as a collection of Greek letters. For example, given two calls with the same maturity but different strikes, one might put on a vertical spread by buying one and writing an equal number of the other. Or one might set up a delta-neutral hedged position which could be short, say, 1.62 of the second option for each of the first option that was purchased. In the second case, it is obvious that the ratio will rarely be an integer value. Option spreads are still very popular positions, frequently with unequal numbers of contracts which makes them ratio spreads. This article looks at how these positions are set up and shows that although the trade is quite common, at least in Eurodollar futures options, the trade tends to be rather different from the (sparse) description found in textbooks. The authors find that in most cases, both options are out of the money when the trade is put on—that is, a frontspread in which potential losses are unbounded because a larger number of contracts are sold than are bought is much more common than a backspread which features unlimited potential profit—and most of the standard explanations for the trade do not seem to hold up in practice

TOPICS: Options, factor-based models, risk management