A Review of Spreads

Whether you are a novice trader having just started earlier this year or a veteran, you know the horrible feeling of choosing the wrong direction on an options bet.

It is, of course, the name of the game:  you buy a call to bet on an upside, or buy a put to bet on the downside.  You choose a direction and being completely wrong can often result in a complete loss with a poor timed trade.

What happens, however, whenever you start selling calls against your purchased, long, strategies?  Or when you sell puts against your existing puts, over or under the original strike?  A variety of new directions open up, including to making bullish bets with puts or bearish bets with calls!

Vertical spreads, such as call debit spreads, might be the most popular of all strategies employed by traders and we have discussed several already, such as but not limited to:

• The put debit spread on Caesars Entertainment, Inc., from October 6th, 2021.
• The call debit spread on Kohl’s Corporation, from October 1st, 2021.
• Or the call debit spread on International Game Technology PLC, from September 23rd, 2021.

Feel free to review any of the above to see how some of the biggest whales take advantage of “simpler” spreads, in an effort to minimize their costs of entries, their potential losses, and enjoy higher probabilities of profit.  If the largest of whales are utilizing these “simple” strategies, then perhaps they are not quite so simple--and should be regarded instead as an amazingly powerful tool to have in one’s toolbox.

There are a plethora of other strategies, most named after animals to make them easy to remember (e.g. the iron condor and jade lizard are more advanced variants and shall be written about sometime soon™️!).

Ratio Spreads

Outside of those, however, there exist the ratio spreads, broken into front-ratios and back-ratios; while these are not named after animals, they are just as approachable and as “simple” as the vertical spreads described above.

Ratio spreads are just vertical spreads, but instead of just two contracts, one long and one short, there exists a ratio of longs to shorts.  Often, the ratio in ratio spreads is 1:2 or 2:1, as in one contract long and two contracts short, or two long contracts and one short.

Front Ratio Spreads

Front ratio spreads have either no downside or upside risk; already, this makes them more powerful than a traditional vertical debit spread.  Front ratio spreads are built just as a traditional vertical debit spread, but instead by selling multiple short side contracts with the long contract.  

The most used ratio spread is 1:2, one long contract with two short contracts.  Usually the long contract is purchased at the money or only slightly out of the money, and the two short contracts are sold further out of the money, but not too far, as the intention is to collect a credit for entering into this trade, as compared to paying a debit.

Again, front ratio spreads are neutral to slightly directional strategies placed so that there is either no upside or downside risk.

A front ratio spread is created by purchasing a put or call debit spread with an additional short put or call at the same short strike of the debit spread.  One long contract against two short contracts.

Maximum profit of such a strategy is calculated by subtracting the strike price of the short positions by the long position’s strike price, then adding that to the credit received from entering into the position.  

The maximum possible profit of a front ratio spread is when the underlying stock price is equal to the price of the short strike; profit decreases to either edge of the break-evens, with one side having no risk whatsoever, and with one side having an infinite risk if the underlying stock price continued infinitely in said direction.

Back Ratio Spreads

Back ratio spreads are identical to front ratio spreads except in that they are long two contracts and short one.  The long positions are typically further out of the money, or at the money, and the short position is deeper in the money.

This strategy offers the benefit of an infinite upside, and even if the stock price does not rise beyond the single short position, in that if it were to expire worthless there could be profit potential.  However, there is no protection on the downside for a call back ratio or the upside for a put back ratio in that this strategy is entered for a debit, which would be lost if the expected trend were violated.

The maximum risk of this strategy as such would be the difference between the strike prices of the long and short positions, minus the debit paid when entering into the position.

The opportunity afforded by the back ratio spread is that one can capitalize upon the greater intrinsic values of two long positions which will override any losses incurred by the single short strike.  Additionally, there is little to no risk of assignment or need for greater amounts of margin upon entering into this strategy.

A Review of Unusual Options Activity & Whales Using Call Ratio Spreads in Ferroglobe PLC (GSM)

On October 8th, 2021, within the Nasdaq Capital Market (NasdaqCM), we saw unusual or noteworthy options trading volume and activity in Ferroglobe PLC, which opened then at $10.65.

These orders were possibly related, having came in together, and represented a call ratio spread:

• There were 7,500 contracts traded on the $9 strike call option at the ask, dated for December 17th, 2021.
• Additionally, there were another 15,000 contracts traded on the $11 strike call option at the bid, for the same date.
• At the time of entry, this strategy would have cost $142,500 for the trader to take on.
• The probability of profit would be approximately 24%, with a maximum return if GSM lands at $11.00 at the time of expiration, resulting in a $1,357,500 profit.

While the aggregate data might not always be 100% accurate, this is a worthwhile trick to investigate options strategies more seriously.  

As can be seen, by clicking through on the  ↕ icon, the additional leg in this GSM trade was revealed.  This could have allowed a clever trader to know that this whale took a safer position--albeit still with a tremendous upside–instead of risking it all on an uncovered call option contract.

N.B.!  Whales do not often trade uncovered positions!  They are almost always covering their positions with shares or shorts in an effort to take advantage of premiums of over- (or under-) priced contracts in an attempt to arbitrage for the best trades possible.  For every buyer there is a seller, and sometimes the safer bets are the best ones in a volatile market!

Interestingly, this front ratio was entered for a debit, which is abnormal, as depicted above; typically front ratio spreads are entered for a credit which secures profit even to the contrarian side of the direction chosen (in this case, to the downside, as this is a neutral to bullish call front ratio spread).

As can be seen, if one were to have entered Friday, October 8th, 2021 per TastyTrade there would have been no loss incurred in this strategy on the downside; only if GSM were to break beyond the $12.67, would this strategy begin to incur losses.  

However, the above trade is now a hypothetical, as the current bid-ask does not allow for this trade to be entered as a credit anymore--and ratio spreads are always best taken on for credit!  The whale was aggressively betting and apparently did not need downside protection.

Ferroglobe PLC’s Outlook & Flow Analysis

Behind every whale order there is almost always some catalyst.  Particularly of note, these orders come after an October 7th report that revealed the "power crunch" in Europe has pressured silicon and ferro alloy producers--specifically that Ferroglobe PLC:

"operates in an energy intensive industry, hence the current energy pricing environment, particularly in Spain, is having an adverse impact on our business”, and that "In recent weeks, we temporarily shut down one furnace at the Sabon (Spain) facility and a furnace at our Boo (Spain) facility to best manage through the energy crisis in Spain."

As of the 8th, GSM has had 22,722 calls traded, which is 454% greater than its 30-day call average.  It must be established that a non-zero amount of these calls were short, as depicted above, but the sentiment of the flow remained bullish on October 8th.

Of those, 55.6% are of bullish premium, with 100% being in calls, 55.6% being ask-side, meaning that all calls traded at this premium level were ask-side.

Comparatively, of the $1,000 or more orders, 55.0% are of bullish premium, with 94.0% in calls, 55.5% being ask-side.  However, of this premium level, 58.1% of the volume was represented by the number of puts traded.

The December 17th, 2021 expiration is the most popular at $7,949,095 bullish premium traded, compared to $6,368,340 premium traded; the most popular strike being the $9 strike option with $2,890,580 bullish premium traded; it must be noted, however, in spite of the unusual options activity aforementioned within this article, the $11 strike still has more bullish premium traded with $1,445,290 premium compared to $1,157,800 bearish premium traded.

A logical deduction, therefore, is that across seemingly all chains bullish bets are being made, and there is an anticipation of a price change by December, so near-term volatility might also be contended with.

Become a Whale by Trading Like One

If whales are utilizing vertical call debit spreads and back ratio spreads, why aren't you?

It can certainly be scary to begin selling short against your long contracts, but these days brokers are doing what they can to support higher options level data and strategies.  

Almost every broker enables its users to use not only margin but also advanced strategies with relative ease in an effort to assist their customers in being long-time customers.  In the past, as has been witnessed, some customers have flown too close to the sun, potentially obliterating their accounts, only to have to leave the trading game altogether--this is not to the brokers benefit, after all--they want you as a long-time customer!

If you are ever afraid of using spreads or have questions, please join us at the Unusual Whales Discord community:  discord.gg/unusualwhales  We would love to meet you and help you with any and all of your questions.

The Discord is free and there are thousands upon thousands of traders just like you who are eager and willing to help and ask for help.  And who knows, maybe after reading this article you can join and help others with managing their call ratio spreads!

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