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Ratio Spreads with the DTI Method

We’ve said it before and we’ll say it many times over in the future: there is always risk when trading the
markets. Throughout each year we will have trades that go against us. That’s just how it goes. So we’ll
continue our series on hedging techniques with options by discussing the ratio spread. In this white
paper we’ll discuss:

1. What is a ratio spread?

2. Simplifying the mechanics of the ratio spread
3. Explaining the risk/reward of a ratio spread
4. Strategy for when to use a ratio spread

Note: if you haven’t read the white papers on RB Orientation and The T-Square, we recommend you do
so before continuing this paper. Links below:

RB Orientation: https://www.dtitrader.com/download/pdf/RBOrientation.pdf
The T-Square: https://www.dtitrader.com/download/pdf/TheTSquare.pdf

What is a ratio spread

Let’s narrow down our discussion and talk about call ratio spreads. Once we learn what a ratio spread is
and then a strategy to use it, we can transfer our knowledge to the put side. We already know that a
debit call spread (sometimes referred to as buying a vertical call spread) is when you buy a call option
and sell a higher strike call option against it. In other words, a normal call spread utilizes a 1:1 ratio.
Taking this strategy a step further, a ratio call spread is when we buy a lower strike call and sell a higher
quantity of higher strike calls against it. In the next section, we’ll keep our discussion simple by
considering a 1:2 ratio spread where we buy one $100 strike call and sell two $105 strike calls.

Simplifying the mechanics of the ratio spread

How is this trade profitable? Let’s break this example down leg by leg. The $100 strike call we buy makes
money as price goes up and loses money as price goes down. Both $105 strike calls make money as price
goes down and lose money as price goes up. That’s leg by leg. Digging deeper we can consider lining up
the $100 strike long call with one of the $105 strike short calls. This of course makes up a simple debit
call spread - defined risk and defined reward. However when we add in the extra $105 short call we are
adding a naked call, which is technically unlimited risk - a very important point to note so we’ll now
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consider the risk/reward profile of a ratio spread using an example with actual strikes and premiums
from the option chain of the SPY.

Explaining the risk/reward of a ratio spread

Let’s take a look at a practical example using the SPY, one of the most popular ETF’s that tracks the S&P
500, and the prices reflect current data as of closing price on Friday, September 11th, 2020. Again let’s
break it down leg by leg:
- Leg 1: Buying to Open one of the Sept 30th, $334 strike calls at around $6.00 (at this point the
trade is outright long a call - our risk is limited to $6.00 and our profit potential is unlimited).
- Leg 2: Selling to Open one of the Sept 30th, $341 strike calls at around $3.00 (at this point the
trade is a vertical call spread at a 1:1 ratio - we’ve technically paid $6 - $3 = $3.00 for this call
spread and our profit potential is the difference between strikes (341 - 334 = 7) minus what we
paid (7 - 3), so $4.00).
- Leg 3: Selling to Open one of the Sept 30th, $341 strike calls at around $3.00 (at this point the
trade is a ratio call spread at a 1:2 ratio)

To find the combined cost of this trade we take the $3.00 we pay to buy the $334/$341 call spread,
minus the extra $3 we collect from selling the second $341 strike call. That equals to $0 of total required
capital (before any margin requirements) to enter this ratio spread at these prices. Please note that we
say required capital before margin requirements and not total risk. The P/L graph below does a good
enough job of describing our risk/reward profile here.

As the graph shows, in this example we have zero risk to the downside for this trade if the SPY goes
below 334. That’s because the premium we bring in for the two short calls makes up for the premium
we pay for the one long call. Remember though that our second short $341 call we sold is technically
naked, meaning we have unlimited risk. Our max profit point is reached if the SPY finishes at 341 on Sept
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30th expiration. If that occurs our 334/341 call spread would be worth $4 and our extra 341 strike call
would expire worthless for another $3, a total profit of $7 per contract. We can then add $7 to our 341
strike to get our breakeven point on the top end of the trade. The reason our risk keeps going is because
we have one naked call, and as the graph shows, if the SPY in this example finished anywhere above 348
we are losing money.

Strategy for when to use a ratio call spread

Now let’s dig into the fun part - implementing the trade with the DTI Method. To do so we are going to
look at the ES (S&P 500 futures) and specifically look at the trading action that happened around our
proprietary Reference Bars. It’s not likely we’ll ever place a ratio spread all at once, so we’ll look at an
example where we leg into each part of the trade. Here are the basic steps, then we’ll narrow down the
details further using visual examples with charts.

- Step 1: Buy a call on a positive Reference Bar

- Step 2: Sell a call to hedge the position and turn into 1:1 spread if timing is off, or if you want to
hedge overnight
- Step 3: another negative Reference Bar in the morning and we can turn the trade into a ratio
spread
- Step 4,5: when time is right to exit the short legs, we can do so separately or all at once

The chart above shows the ES (S&P 500 futures) trading action over the past three days. This 3-day
picture may not look like much right now, so below we’ll break this down into the three separate days.

Day number one below shows S&P futures opening up at 5pm CT with RB1 (the first blue bar). All
throughout the Asia European time segments we saw bullish action. What that tells us is to be ready to

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take action in the morning during the U.S. markets. Sure enough, we get a very positive RB3, offering a
great opportunity to get long. The trade works, rising all through the morning session. Then we start a
new time segment with RB4 and the start of afternoon trading. Reference Bar 4 ends up being negative
which is a warning sign for longs. Then some more significant selling steps in during the last ½ hour. This
provides us an opportunity to turn our outright call that is currently profitable into a vertical call spread,
and for now we’ll leave the trade as a normal 1:1 ratio.

Note that we still have not turned this trade into a ratio spread. We’ve turned this into a vertical call
spread because we are optimistic that our bullish direction will continue. Turning the trade into a spread
allows us to hedge the position well overnight. If we thought the bullish action was done we would just
exit the trade at profits. Or, if we couldn’t make any more day trades, we could place this hedge and exit
the next morning.

Now on to day two with the snapshot below. The start of day two brings indecision from traders during
Asia and Europe. When the U.S. market opens we immediately start to see a more clear picture for the
day’s trading following Reference Bar 3. Notice that RB3 forms with again indecision from traders. The
next bar forms and we close below the midpoint of RB3, which is also very close to the low of the range.
Then during the next half hour we see bearish traders take control as the ES breaks down below its RB3
range.

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Now if the trade is profitable at this point, we could just exit the trade, especially if we are close to
expiration with not much time to recover and/or if we think our longer-term uptrend is over. However,
if we have plenty of more time for the trade to play out, and would prefer to hedge even more because
we believe any selloff will be temporary, this would be a good time to consider turning the position into
a ratio spread. By the time we see RB4 go negative if we’re still in the trade, we’re presented with an
even clearer signal that if we want to stay in the trade we need to add another hedge of some kind - in
this case selling another call, turning the trade into a ratio spread.

At this point we have the full ratio call spread on and we’re in a great position to let time now work in
our favor. Our work is far from over though. Remember that we now have a naked call as part of our
total position, and we’re going to buy that back when the time is right. So how do we know when the
time is right to buy back the calls? We go back to the DTI Method and our Reference Bars.

The snapshot below shows day three, where we see more indecision during Asia and Europe before
volatility picks up when the U.S. market opens up. Reference Bar 3 opens the U.S. morning segment and
we see breaks on both sides of the RB3 range but no closes above or below that until late in the
morning. That means we can stay in our current position.

Once we’re in an ideal market position, a lack of clarity in the market

tells us to keep our hands in our pocket.
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Then we get to Reference Bar 4 which does go positive. This is the first clear RB signal that we’ve gotten
since turning the trade into a ratio spread. We can use this opportunity to exit the naked call and turn
the position back into a 1:1 vertical call spread, but since this was a Friday and the ES was below a very
important weekly number, we can really view this from two frames of mind.

On the one hand we have a fairly clear RB4 signal that is telling us we might want to buy back the naked
call so that we get back to a defined risk:defined reward trade going into the weekend. On the other
hand, in this example, we know that the weekly open was 3420 and the ES stayed below the week open
for the vast majority of the week. By all accounts that is more bearish than bullish, so there is also a
strong case that we should remain in our ratio spread over the weekend to see how the ES opens up the
next week.

Whatever we decide to do, we never lose sight of the bigger picture. The reason we decided to turn the
trade into a ratio spread is because we think that from a longer-term time frame the bullish direction
will prevail. So once we’re in the ratio spread our next steps are to find good times to leg out of our
short calls and ideally end up outright long again for the next leg up. We use our Reference Bar
approach to make those decisions, just like we did to enter the trade, and put the odds in our favor for
success.

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We hope that you can clearly see the value of using a 24-hour approach and DTI’s Reference Bar’s to
help make trading decisions. Trading is not an easy game we play. So it is vitally important to use the
process created by Tom Busby to analyze the market and make educated decisions to increase the
probability of making the correct decision. We can use the Reference Bar concepts taught in this paper
and past white papers to give us a competitive trading edge, and we can do so every step of the way.

Trade to Win!

The DTI Team

Diversified Trading Institute

1555 S University Blvd, Mobile, AL 36609
(251) 652-1555
(800) 745-7444

Article written by Jonathan Rowe

All insights are that of Tom Busby

All material included in this article is for educational purposes only

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