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Use the Ratio Spread to Stay in Winning Positions

September 15, 2011 by John Payne| Tips & Strategies

The financial markets provide participants with difficult decisions in every situation. An envious but no less difficult position is one that involves a winning trade. There comes a point when the desire to take profits overcomes the desire to stay in that profitable position. The psychology involving loss of profits can be even harder to master than the psychology of entering a trade and facing loss of principal. We hear it often in common investing mantras – “hogs get slaughtered”. Keeping that in mind, how does one know which winners to let run and when to not be a greedy pig? The answer might be more strategic than psychological.

The Corn market has put many in this position. One year ago, the market for December 2011 corn was trading just over 4.50. Strong fundamentals combined with loose monetary policies have created a demand for the product from not only a production standpoint, but an investment perspective as well. Those with the foresight to have purchased corn a year ago would be sitting on a solid winner with December corn around $7.40 today. However, with the recent European crisis coupled with high prices curbing demand, the holders of length in the market face tough trading decisions. Do they cut the trade short? Or do they hang on in hopes of continued supply shortages and a push over $8.00?

The savvy trader will look to his trusty option tool belt. Much like Batman’s utility belt, traders need to have tactics at their disposal to assist them while combating any perceived market situation. View using options like Bruce Wayne uses his crazy weapons to escape stressful situations. Regarding the case described in corn, one should look to the ratio call spread as a way to hedge some downside risk while giving themself the chance to profit in case of a move higher.

STRATEGIES USING COMBINATIONS OF POSITIONS, SUCH AS SPREAD AND STRADDLE POSITIONS MAY BE AS RISKY AS TAKING A SIMPLE LONG OR SHORT POSITION.


The ratio call spread involves the simultaneous purchase of a call with the sale of two or more calls. In this example, our ratio spread will be a one to two, buying one close to the money call and selling two further out of the money calls. Because we’re assuming that the corn market might be a bit “toppy”here, we want to do this spread at a “credit” – this means that we will collect a higher premium from the sale of the two calls versus what we’d spend on the premium for the long call. Let’s look at an example:

The Trade

Glen has been long one December Corn futures since it was at 5.00. He is a long-term thinker. Glen believes that because of the inability of the government to print more corn combined with their ability to print more money, the corn market will go up drastically over the medium term – possibly as high as $10.00. Alternatively, because of the constant US/European financial crises, he knows his position could see heavy liquidation if these crises were to escalate in the short run. He could just exit the trade and wait for these crises to pass, but he also understands the upside risk that exists due to these central banks devaluing their currencies to solve their issues. In his opinion, this would cause the rally to continue and doesn’t want to miss it.

At this moment, December Corn is trading at 7.40. With the harvest season around the corner and farmers selling their crops, we typically see a drop in prices. Glen is going to look to buy a ratio call spread at a credit to protect some downside risk. He will look to buy one 7.70 December Corn call and will sell two 8.00 December Corn calls expiring in 74 days.

  • Buying 1 Dec 770 call for 30 cents, paying $1,500 before fees
  • Selling 2 Dec 800 calls for 23 cents each (46 cents combined), collecting $2,300 dollars before fees

This move will give Glen 16 cents of downside protection while capping his profits on corn at 8.00 over the next 74 days, which will cover his long futures. The spread also has an upside – if corn expires over 8.00, Glen would collect maximum profit on the difference between his long 7.70 call and short 8.00. That would give him another $1,500 in profit to go along with the profits he will receive from his long futures contract from 7.40 to 8.00 ($3,000).

PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.


In the short run, the ratio spread will make money as the corn market falls, offsetting some of the losses Glen will take on his long corn contract. If the market would rally higher, Glen will make money up until 8.00 from his futures contract and call spread. The risk from putting himself in this position would be the elimination of profits over 8.00. Glen accepts that risk because he knows there is no such thing as a free lunch and is fine sacrificing profits over 8.00 for protection here at 7.40. It is that tradeoff that will compel him to get involved in a spread like this.

STRATEGIES USING COMBINATIONS OF POSITIONS, SUCH AS SPREAD AND STRADDLE POSITIONS MAY BE AS RISKY AS TAKING A SIMPLE LONG OR SHORT POSITION.


The ratio spread works well in accompanying positions for any trending market. This trade might also work well for those who have been long commodities like Gold, Bonds or Sugar. For more questions on developing your own option tool belt, please contact a Daniels Trading broker.

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Filed Under: Tips & Strategies

About John Payne

John Payne is a Senior Futures & Options Broker and Market Strategist with Daniels Trading. He is the publisher of the grain focused newsletter called This Week in Grain, along with being a co-editor of Andy Daniels’s newsletter, Grain Analyst. He has been working as a series 3 registered broker since 2008.

John graduated from the University of Iowa with a degree in economics. After school, John embarked on a 4 year career with the United States Navy. It was during two tours in Iraq and the Persian Gulf where John realized how important commodities are to the survival of society as we know it. It was this understanding that brought about John’s curiosity in commodities. Upon his honorable discharge in 2007, John’s intense interest in the world of commodities inspired him to move to Chicago and pursue his passion in a career in the futures arena.

After a three year position with a managed futures firm specialized in livestock trading, he was given the opportunity to join the team at Daniels Trading. Being in the business and seeing how other IB’s operated, it was the integrity and straightforward approach of the Daniels management team and brokers that attracted him to make the move. Since joining Daniels, John has broadened his fundamental and technical analysis of the markets even further. John has been writing his newsletter This Week in Grain under the Daniels banner since 2011.

Working in high pressure industries like the military and capital markets, John has learned the value of preparation in times of stress. He believes that instilling within his clients the value of a good plan and a cool head for dealing with the day to day swings of commodity markets. He treats every client as a teammate, understanding that his job is to help clients achieve their goals, whatever they may be.

John is a proud supporter of the Iraq and Afghanistan Veterans of America, the Veterans of Foreign Wars and the National Corn Growers Association. When he is not working, he enjoys athletics of all kinds and spending time with his wife and their two kids.

John’s commentary is featured in the following publications:

* All Ag Radio – Sirius Channel 80
* AM 880 KRVN – Lexington, Nebraska
* RFD TV
* Wall Street Journal
* Barron’s
* China News Daily (English version)

Risk Disclosure

This material is conveyed as a solicitation for entering into a derivatives transaction.

This material has been prepared by a Daniels Trading broker who provides research market commentary and trade recommendations as part of his or her solicitation for accounts and solicitation for trades; however, Daniels Trading does not maintain a research department as defined in CFTC Rule 1.71. Daniels Trading, its principals, brokers and employees may trade in derivatives for their own accounts or for the accounts of others. Due to various factors (such as risk tolerance, margin requirements, trading objectives, short term vs. long term strategies, technical vs. fundamental market analysis, and other factors) such trading may result in the initiation or liquidation of positions that are different from or contrary to the opinions and recommendations contained therein.

Past performance is not necessarily indicative of future performance. The risk of loss in trading futures contracts or commodity options can be substantial, and therefore investors should understand the risks involved in taking leveraged positions and must assume responsibility for the risks associated with such investments and for their results.

Trade recommendations and profit/loss calculations may not include commissions and fees. Please consult your broker for details based on your trading arrangement and commission setup.

You should carefully consider whether such trading is suitable for you in light of your circumstances and financial resources. You should read the "risk disclosure" webpage accessed at www.DanielsTrading.com at the bottom of the homepage. Daniels Trading is not affiliated with nor does it endorse any third-party trading system, newsletter or other similar service. Daniels Trading does not guarantee or verify any performance claims made by such systems or service.

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Risk Disclosure

This material is conveyed as a solicitation for entering into a derivatives transaction.

This material has been prepared by a Daniels Trading broker who provides research market commentary and trade recommendations as part of his or her solicitation for accounts and solicitation for trades; however, Daniels Trading does not maintain a research department as defined in CFTC Rule 1.71. Daniels Trading, its principals, brokers and employees may trade in derivatives for their own accounts or for the accounts of others. Due to various factors (such as risk tolerance, margin requirements, trading objectives, short term vs. long term strategies, technical vs. fundamental market analysis, and other factors) such trading may result in the initiation or liquidation of positions that are different from or contrary to the opinions and recommendations contained therein.

Past performance is not necessarily indicative of future performance. The risk of loss in trading futures contracts or commodity options can be substantial, and therefore investors should understand the risks involved in taking leveraged positions and must assume responsibility for the risks associated with such investments and for their results.

Trade recommendations and profit/loss calculations may not include commissions and fees. Please consult your broker for details based on your trading arrangement and commission setup.

You should carefully consider whether such trading is suitable for you in light of your circumstances and financial resources. You should read the "risk disclosure" webpage accessed at www.DanielsTrading.com at the bottom of the homepage. Daniels Trading is not affiliated with nor does it endorse any third-party trading system, newsletter or other similar service. Daniels Trading does not guarantee or verify any performance claims made by such systems or service.

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