Selecting the Optimal Underlying Asset for the Ratio Call Spread

Introduction

The success of a ratio call spread is not solely dependent on the trader's skill in executing the strategy; it is also heavily influenced by the choice of the underlying asset. Not all stocks are created equal when it comes to their suitability for this advanced options strategy. The professional trader must conduct a thorough analysis of the underlying asset's characteristics to identify those that are most conducive to the unique risk/reward profile of the ratio call spread. This article will provide a comprehensive guide to selecting the optimal underlying asset for the ratio call spread, focusing on the key factors of liquidity, volatility, and trend.

Liquidity: The Sine Qua Non of Options Trading

Liquidity is the lifeblood of options trading. It refers to the ability to buy or sell an asset quickly and at a fair price. For a multi-leg strategy like the ratio call spread, liquidity is of paramount importance.

• Tight Bid-Ask Spreads: Liquid options have tight bid-ask spreads, which means the difference between the price at which you can buy an option (the ask) and the price at which you can sell it (the bid) is small. A wide bid-ask spread can significantly increase the cost of entering and exiting a trade, eating into your potential profits.

• High Open Interest and Volume: Open interest is the total number of outstanding option contracts that have not been settled. Volume is the number of contracts that have been traded in a given day. High open interest and volume are indicators of a liquid market, where it is easy to find a counterparty for your trade.

Rule of Thumb: As a general rule, you should only trade options on stocks that have an average daily trading volume of at least 1 million shares and options with an open interest of at least 100 contracts.

Volatility: The Engine of the Ratio Call Spread

As we have discussed in previous articles, the ratio call spread is a negative vega strategy, meaning it profits from a decrease in implied volatility. Therefore, the ideal underlying asset for a ratio call spread is one that has a high implied volatility that is expected to decrease.

• Look for High Implied Volatility Rank (IVR): IVR is a measure of the current level of implied volatility relative to its historical range over the past year. An IVR of over 50% is generally considered to be high. By entering a ratio call spread when IVR is high, you are increasing the probability that implied volatility will contract, which will benefit your position.

• Avoid Earnings Announcements: Earnings announcements are a major source of uncertainty and can lead to a significant increase in implied volatility. It is generally advisable to avoid holding a ratio call spread through an earnings announcement, unless you have a very strong conviction that the stock will not make a large move.

Trend: The Directional Bias

The ratio call spread is a moderately bullish strategy. Therefore, it is best suited for stocks that are in a mild uptrend or are trading in a range.

• Identify Stocks in a Channel: A stock that is trading in a well-defined channel is an ideal candidate for a ratio call spread. You can set the long strike price near the bottom of the channel and the short strike price near the top of the channel.

• Avoid Highly Trending Stocks: A stock that is in a strong uptrend is not a good candidate for a ratio call spread. The unlimited risk of the strategy makes it too dangerous to trade in a stock that has the potential to make a large upward move.

A Practical Checklist for Selecting the Underlying Asset

Here is a checklist that you can use to screen for potential candidates for a ratio call spread:

• Liquidity
  • Average daily stock volume > 1 million shares
  • Option open interest > 100 contracts
  • Tight bid-ask spreads
• Volatility
  • Implied Volatility Rank (IVR) > 50%
  • No upcoming earnings announcements
• Trend
  • Stock is in a mild uptrend or trading in a range
  • Avoid stocks in a strong uptrend

Conclusion

Selecting the right underlying asset is a important first step in the successful implementation of a ratio call spread. By focusing on liquid, high-volatility, and range-bound stocks, the professional trader can significantly increase their probability of success. The checklist provided in this article offers a systematic approach to screening for potential candidates, but it is no substitute for thorough due diligence and a deep understanding of the underlying asset's fundamentals and technicals.