Taking Advantage of Time Decay With a Mixed Ratio Spread

As you can see in the chart below, the price of Canadian Pacific Railway Limited (CP) stock has stayed within a range of $215 to $240 since October 2017 and $190 to $240 over the last 12 months. While the price could fall back down to $190, equal to a drop of nearly $35 from the current level ($224.16), we also believe that a $35 increase to $260 could be equally possible.

Daily graph as at April 11, 2018 ($224.16)

Assuming that CP’s price will remain within a range of $190 to $260 over the coming months, an investor could implement a mixed ratio spread strategy consisting of a ratio call spread and a ratio put spread. A ratio call spread involves purchasing one call option while selling two call options at higher strike prices. It is essentially equivalent to a bull call spread combined with an additional call option. A ratio put spread involves purchasing one put option while selling two put options at lower strike prices. This is equivalent to a bear put spread combined with an additional put contract. As shown in the above graph, combining the two strategies allows us to make a profit if prices remain stable and close within a given price range when the options expire.

Position

Mixed ratio spread

• Ratio put spread
• Purchase of 10 put options CP 181019 P 220 at $11.55
  Debit of $11,550
• Sale of 20 put options CP 181019 P 210 at $7.75
  Credit of $15,500
• Net credit of $3,950

• Ratio call spread
• Purchase of 10 call options CP 181019 C 240 at $7.50
• Debit of $7,500
• Sale of 20 call options CP 181019 C 250 at $4.50
  Credit of $9,000
• Net credit of $1,500

Total credit of $5,450

Profit and loss diagram for the mixed ratio spread on CP expiring on October 19, 2018

The mixed ratio spread we set up consists of a ratio call spread and a ratio put spread with a ratio of 10 contracts bought for every 20 contracts sold. The ratio put spread generates a credit of $3,950 while the ratio call spread allows us to collect a credit of $1,500 for a total credit of $5,450. This credit corresponds to the minimum profit that can be realized if CP closes at a price between the strike prices of $200 and $260, with a maximum profit of $15,450 if CP closes exactly at the strike price of $210 or the strike price of $250. This strategy will be profitable as long as CP stays between the breakeven prices of $194.55 and $265.45, but will generate a loss if it strays outside this range. As a result, we have quite a bit of leeway on both the upside and the downside before we would need to take action.

 
Intervention

This strategy makes it possible for us to profit from time decay. As long as CP stays between the two breakeven prices, we do not need to intervene in any way. However, as losses could be substantial beyond the breakevens, we must intervene by liquidating the position if CP breaches either of these thresholds.

 
Good luck with your trading, and have a good week!

 
The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.