Put Ratio Spread Case Study
The Put Ratio Credit Spread, similar to the “naked put”, has nearly unlimited loss potential when the underlying price falls, while it has very little profit potential if the underlying increases in price. This strategy falls into the high POP (Probability of Profit) category, but the risk-to-reward ratio is at a serious disadvantage. One loss […]
The Put Ratio Credit Spread, similar to the “naked put”, has nearly unlimited loss potential when the underlying price falls, while it has very little profit potential if the underlying increases in price.
This strategy falls into the high POP (Probability of Profit) category, but the risk-to-reward ratio is at a serious disadvantage. One loss can wipe out years of gains, so if you are considering this trading strategy, you might want to meditate on it a little longer.
In addition to risk-to-reward ratio problem, the trade also has an exploding margin issue, especially when trading a portfolio margin account (risk-based margins). For this reason, the trade does not typically profit long-term.
In this article we look at the behavior of this options strategy over a normal market pullback.
September 9, 2016
On 9/9/16 the SPX dropped 49.69 points for a change of -2.28%.
Below we see the initial margin of the trade is $105K, which is measured at the -10% risk array according to standard TIMS methodology.
The following day the margin increased by $45K for a total increase in margins of 48%.
While the margin increased by 48%, the trade also experienced a 12% single-day drawdown as shown below.
Possible Scenarios to Consider
If the trader was using 70% of their buying power, this ordinary day would have resulted in a margin call for $12,000. The margin increased to $150K and their NAV decreased to $138K, so the margin exceeded the account value by $12K.
If the SPX dropped another 2.28% the following day, then margins would have increased by approximately 96%, and the trade would have lost approximately 24%. At this point, margins would have increased to approximately $200K while the user’s NAV would have fallen to $126K, resulting in a margin call of $74K in only 2 days.
Obviously, the SPX could have dropped 4.56% in one day, which would have resulted in a substantial margin call overnight and most likely an account liquidation, causing additional financial damages to the trader.
The Put Ratio Credit Spread can be an extremely dangerous trade for option traders, fund managers and advisors. Margins can double in a matter of minutes while it’s not uncommon to lose 12% or more nearly instantly. Margin calls are frequent, which are followed by account liquidations. In today’s example we see what happened to this spread over a mundane market move. Imagine what would happen to this spread during a serious market decline. If you are considering this type of options trade, you might want to think again.
SJ Advisor Method
The SJ Advisor Method is designed to prevent such margin problems and uncontrollable drawdowns. Typically, when the market falls, our margins do not increase. This allows our clients to manage their portfolios safely – without margin issues. Additionally, our drawdowns are normally about 1/10 of the drawdowns experienced with popular spreads such as naked puts, strangles, credit spreads, condors, put ratio credits and the like.
As always, best of luck with your trading, and we look forward to seeing you in our next class.