Convert a Collar Feature to a Ratio Kick

There are three potential scenarios for the collar position here: we can hold it until expiration, we can walk away from the trade once our target price has been hit, or we can convert it. In the example above, we converted the collar trade to a bullish call spread. In this example, we will convert the collar into a ratio spread, also known as a call backspread.

A standard definition of a ratio spread can be found on Investopedia as “an options strategy in which an investor simultaneously holds an unequal number of long and short positions. A commonly used ratio is two short options for each option purchased.” So depending on who you talk to, when you buy more options than you sell, you essentially find yourself in what’s known as a callback or relationship rollback.

The key difference is that a standard ratio margin exposes you to unlimited risk, because you have an extra short position, while a reverse ratio margin exposes you to unlimited profit potential, because you have an extra long position. Regardless of the technicality of the name, selling one option and buying two options is less risky than buying one option and selling two options. Therefore, you will always want to do the first, not the second, if your goal is to manage your risk.

Hold him

In the example found in Table 1, all indicators point to a short position in the corn market. Making a protection call at $ 5.10 protects the position from any sudden upward movement. The call costs $ 1,000. To offset the costs of the call option, a put option can be sold at a support point, $ 4.30. The sold put option brings in a $ 250 premium.

Table 1: Classic Corn Collar Holder

Short Futures Buy Put Protective Sell for

Call / Premium Income / Premium

Collected

Entry $ 5.10 $ 5.10 (- $ 1,000) $ 4.30 (+ $ 250)

Departure $ 4.30 $ 4.30 (- $ 1,000) $ 4.30 (- $ 250)

Simply holding the trade to maturity results in a $ 1,000 deduction from your earnings. The call option expires worthless, leaving $ 3,000 in profit. The put option sold has to reach $ 4.25 before it can be considered profitable (determined by subtracting the strike price from the premium charged), and even if it reaches that low level, the short futures position may end up hedging your losses. A simple profit of $ 3,000 can be achieved if the exchange is kept up with little fanfare.

Risk

The risk of this collar is no different from the risk associated with the first example. Holding onto a necklace until expiration exposes the position to multiple ups and downs in price as the market fluctuates. This occurs without the guarantee that the underlying futures position will actually reach the resistance level at which the put option was sold. Any lack of momentum from the underlying futures contract will lessen the impact of the put option sold. By itself, the option sold cannot produce a significant source of income to cover the option that was purchased, nor will it offset the disappointing results of the future contract. This leaves the trader with a maximum chance of winning $ 3,000 and at the same time leaves the trader open to making much less.

Walk away

If the market is moving in the right direction but there is no desire to hold the trade until expiration, then the trade can be settled early. When we look at Table 2, we can see that the market has reached the $ 4.30 level, but it simply cannot break above the $ 4.10 level. Tremendous support has built up in the range of $ 4.30 to $ 4.10 with the potential for the market to turn up and down at any moment.

With the threat of that happening, it may be better to exit the trade without waiting for expiration.

Table 2: Classic Corn Necklace Clearance

Short Futures Buy Put Protective Sell for

Call / Premium Income / Premium

Collected

Entry $ 5.10 $ 5.10 (- $ 1,000) $ 4.30 (+ $ 250)

Output $ 4.30 $ 4.30 (+ $ 150) $ 4.30 (- $ 700)

Profit / Loss + $ 4,000 – $ 850 – $ 450

Risk

Exiting the trade before expiration involves two additional costs associated with the trade, both of which will reduce profits. First, by exiting the protection call, you will be penalized. While you don’t lose the entire $ 1,000 calling premium, there is a chance that this could happen. In this example, you end up losing $ 850.

The same problem arises for the sold put. The put option must be repurchased at the exchange rate prevailing in the market. You initially charged a premium of $ 250, but now you have to pay $ 700 to exit the position, which brings your put loss to $ 450. This gives your corn position a total loss of $ 1,300 against a profit. fund of $ 4,000. This leaves the corn position with a net profit of $ 2,700.

Convert it

The decision to set a ratio differential can be difficult. There may be a feeling that the market will continue to decline, but you don’t want to expose your earnings to any pullbacks, nor do you want to exclude yourself from future short gains solely because you sold a put option.

That’s when the relationship differential comes into play. If we look at Table 3, we can see the nascent beginnings of converting a collar to a ratio differential.

Since there is a new support area developing around the $ 4.10 level, we decided to take a portion of the profit and reinvest it in buying two put options. The intention is to have all of our future short-term earnings locked into our account, while at the same time avoiding taking a loss on the sale we sold.

Holding the futures short position until it reaches $ 4.10, we get an additional $ 1,000, bringing our futures total to $ 5,000. By doing this, we ensure that any potential loss incurred from the put option we sold is covered between $ 4.30 and $ 4.10. It also gives us a bit more capital to buy the two put options at $ 4.10.

A put option continues to hedge the put option we sold, lowers our unlimited risk and allows us to exit our future position. The second option is our source of income. For $ 900 we can free up the principal in our account by eliminating the corn margin requirements, and still participate in the price drop and any potential possibility of collecting the premium.

Table: Conversion of classic corn collar to recoil ratio

Short Futures Exit Call Sell Put / Premium Buy two puts to continue short

Entry $ 5.10 $ 5.10 (- $ 1,000) $ 4.30 (+ $ 250) $ 4.10 ($ 450 / each or $ 900)

Output $ 4.10 $ 4.30 (- $ 1,000) $ 3.70 (- $ 2,400) $ 3.70 ($ 2,000 / each or $ 4,000)

Profit / Loss + $ 5,000 – $ 1,000 – $ 2,150 + $ 3,100

In Table 3 we see that the operation has completely exited: no call, no put, sold or bought. The time it takes to get to that point is almost four months. This is definitely a change of position.

Risk

There are a number of drawbacks to converting the collar to this type of ratio extension. The first problem is the number of variables you have to deal with before the final execution of the short futures trade. If you hold the futures short position for too long, the market has a chance to rally and get your profit back.

A second problem arises when buying the two additional put options. While they are slightly out of the money, they have the ability to be quite expensive compared to the premium you charged from the sale. In fact, the expense can far outweigh the benefits of continuing to trade.

Finally, a trade that originally only took 26 days to make a profit now takes 103 days before you get all your money, and all the time you are not sure if the trade will work. This is almost a quadruple of your trading time frame with little guarantee that the market will continue to decline. If the market moved against your two put options, you would lose the $ 1,100 in premium. This risk may simply not be worth it. That is why it is important to do your calculations before executing a trade like this.