Every few months there comes a time when there is lack confidence on direction but lot more conviction on volatility. In such times generally we do go on a backfoot and avoid to trade. However, one such strategy that comes in handy while trading such view is Back Ratio Spread.
A situation, where we have firm view on volatility that there is a very bright chance of movement, the choice of Bull or Bear for a Biased Volatility can be made easily with choice of instrument Call or Put.
Back Ratio Spread is a strategy where for Bullish Biased Volatility, we need to Sell a Call of the strike closest to the current underlying level and Buy not 1 but 2 lots of a higher strike Call. If we wish to trade Bearish Biased Volatility view, we choose Puts. Here, we need to sell a Put of the strike closest to the current underlying level and buy 2 lots of a lower strike Put.
What this ends up doing at the beginning is it reduces the premium outflow considering the Higher calls/Lower Puts cost lower then the Call/Put of strike close to current level.
The situation we have at hand generally in these times is expecting either a big move upon crossover of the known hurdle on up/downside or similar if not equally fierce but a move in opposite direction in case of a failure. This gives limited probability to the underlying meandering around the same level.
Now for the outcome, in case the breakout or breakdown does come along the Call/Put sold does start bleeding but after a brief move rising impact of the 2 bought Calls/Puts come into play. This will help as in case of big moves loss in 1 Sold Call/Put will eventually be compensated and favorable pay-off will created by 2 bought options against one sold.
On the flip side if there is failure, meaning we were expecting a big respite and there ends up a break down with a Call Back Ratio Spread or vice-versa (with Put Back Raio Spread). We will still be better off than the rest of the market.
This is because the premium out flow (net cost) of creating this strategy is always very small or at times one ends up getting some premium inflow. Eitherways, as long as our view on Volatility is correct, even being wrong will not have any big impact as the most one can lose in this strategy is the tiny premium paid while creating the strategy.
The only thing that could create negative pay-off is if the underlying stops and does not move. Our call on volatility goes wrong. The maximum loss can be difference between bought and sold strikes. This could hurt, but there is a remedy.
The trades shall be taken with a time stop loss of 2-4 sessions. In case if exit is not triggered within that time frame (big move does not come thru), exit the trade and wait for another trigger. This strategy could cost you dear in terms of time value with 2 Options Buy Vs 1 Sell if not exited within 2-4 sessions.
However, there is a caveat, the benefits of this strategy starts to fade as we go close to the expiry, hence advisable to avoid this trade in the final week of expiry. In such situation simple single option trades would do as the premiums must have come off due to limited time value remaining.
This is one of the safest strategies if executed along with entry (not close to expiry) and exit (within 2-4 sessions) criteria applied. Be vigilant of the limitations of it and make the most of any possible Volatility with a directional bias.
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