Introducing the futures options Ratio Credit Spread.
What I really like about using this type of futures option spread is the added staying power it gives me if a market gets choppy.
This will be the final futures options spread lesson. This is another option spread I utilize quite often as a CTA (Commodity Trading Advisor) and tend to have good success with it.
For this lesson, I’ll be using the Natural Gas futures contract. As you can see in the futures chart below, Natural Gas prices had been falling over several months. Rather than just selling a naked Call option, I’ll use a Ratio Credit Spread as I know from past experience; the Natural Gas market can be volatile at times.
The set up looks like this…
I’m going to sell three (3) 3.400 Natural Gas Calls and then I’ll use part of the premium I collect from the sale and buy one (1), closer to the money, 3.300 Natural Gas Call. The spread now has a 3:1 ratio and I received a net credit, thus the name Ratio Credit Spread.
In using a futures option Ratio Credit Spread, we are gaining the following three benefits as opposed to just selling an option outright (not in a spread)…
- Longer staying power. If Natural Gas futures started to get volatile and have a large jump in price, my long Call would offer protection and help offset some of the losses on the three short Calls as our long Call is closer to the money (current futures price). This would enable me to ride out the volatility and re-analyze the trade if necessary.
- Lower margin requirement. By trading a spread, we can benefit by lower margin requirements as opposed to selling the futures options outright. In this example, the margin difference is over 40% lower for the futures option spread.
- Opportunity for greater profits. This is one of the key benefits of the Ratio Credit Spread that I really like and isn’t found in any of the other spreads I use. Using the above example, we would have collected 27 points ($270) for each 3.400 futures option Calls we sold for a total of $810 in premium. We then would purchase one 3.300 futures option Call for 39 points ($390) giving us a net credit of $420. In normal credit spreads, your net credit received is your maximum profit available (less any commissions and trade fees) but not with a Ratio Credit Spread. In this example, our maximum gross profit is $1,420, over 3 times greater than just the net credit received!
Let me explain how this works.
Because we are using a 3:1 ratio at different strike prices, we have room for additional profit. If the Natural Gas futures options expire with the Natural Gas futures price trading anywhere between 3.300 and 3.400, we would have additional profit above our net credit collected. If, for example, the Natural Gas futures price were to be at 3.375 at the time of the futures options expiration, we’d receive a total gross profit on this spread of $1,170.
For the mathematicians out there, here’s how we calculate this…
With the Natural Gas Futures price at 3.375 at expiration, our three short 3.400 Calls would expire ‘out-of-money’ worthless and we would keep the $810 in premium collected. Additionally, the 3.300 futures option Call we purchased would be worth 75 points or $750 less the $390 we paid for it for a profit of $360. Add this to the $810 in premium and we get a total profit on the trade of $1,170 ($810+$750-$390).
To reach our total maximum profit of $1,420, Natural Gas futures would have to close at exactly 3.400 on the day the futures options expire, which would be extremely rare.
Of course, we do have some downsides to the Ratio Credit Spread. Because this is a spread, we typically have to hold the trade longer to realize a profit. We also will have higher trade commissions and fees as we are trading multiple contracts.
If prices were to continually rise, the breakeven point of this futures options spread would be with the Natural Gas futures prices at 3.450 (I won’t go into the math at this time on how to calculate the breakeven point but anyone interested can contact me at 1-847-379-5000). Beyond the breakeven price, you would start to lose money on this spread.
As always, no futures option strategy is guaranteed to produce profits. This strategy can result in a loss. It’s important to determine both the profit and loss you are willing to accept for every trade you enter, before you enter the trade and always, remember to account for commissions and trade fees when calculating your profits and losses.
This post concludes my futures options spread lessons. I hope you’ve found this futures option information valuable. I know options trading can get a little confusing, especially when we start introducing spreads. If you have any questions about any of the futures options trading strategies outlined, please feel free to contact me.
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