One of tonights trades from Dan on Options Action was the May 7x6 put ratio spread for .05 debit.. i put on the same trade but for April. just want to make a few comments about this type of trade since it always bugs me when i see the description. you will:
Buy 1 of the May 7 puts and
Sell 2 of the May 6 puts
you will pay 5 cents ($5) for each 1x2.. so you put this on with the presumption that the stock will pull back. your reason for putting this on can varry.. almost free hedge against long stock, outright short belief, etc
The profit range at Opex in May will be pretty much from 5-7 with max profit being right at 6 bucks..now i can talk in option "greeks" but im not pretending to be some big time trader so ill keep it in english and pretty simple.. if the stock pulls back tomorrow to 6, you will not make that huge 95cent profit since the may6 puts will also increase in value..likely in excess of what you gained on the may7 puts.. so you will have to wait all the way till may to realize the big gain. you have to wait for the time decay of the may6 puts. thats the first thing that annoys me about these type of trades that gets overlooked or not mentioned.
2nd, there is the usual paragraph about how you may get "put" the stock if its under the $6 price..this is correct but it also means at Opex time, not now. if it pulls back to $5.90 tomorrow, you will not be put the stock on that extra may6 put.. that will only happen if you do not close the trade out prior to expiration in may. Breakeven is mentioned to be $5.05.. meaning if stock drops below that at Opex, THEN this ratio spread loses money. but you dont have to sit there and let your broker exercise the options(ie, force you to buy 100 shares of stock at $6), you can close the spread at a loss. That part never seems to get mentioned, you can just close the trade..just like you should close the trade for a profit if stock is at $5.95
3rd, this is not a free trade, you have to set aside enough buying power/margin to buy those shares at $6 if you dont close out that extra short may 6put.. so figure about $600 margin needed for every set of 1x2 ratio you buy. so if you were thinking of buying BAC at $6 a few weeks ago or would like to again and have $6000 in buying power available for that purchase.. you could put on a 10lot of this ratio.. buying 10 may7 puts, selling 20 may6 puts all for $50 of risk.
Sooooo... then you have to wait till near May opex then:
1. if stock is above $7, you lose just $50
2. stock anywhere between 5-7, close out both sides for profit
3. stock is below $5, then close out both sides for loss, unless for some reason you want to buy the stock (have it put to you at $6 )
i like these trades because you only pay a few cents for a high probability profitable trade.. in some cases you can do this trade for a credit and get paid to wait / paid even if stock closes above $7 in this example