Questions about credit ratio spreads with options

[Claybie]

I've been studying for years and have finally decided to start trading. I need help, though. It seems as though it is very tough to lose much (if any) money when I find a ratio credit spread that is greater than 3x1 when both legs are OTM and you monitor/exit before the short leg gets ATM. Please tell me why I'm wrong.

Here's the example: VXX is trading at, say, $22. One week out, the $20 put is at $.05, the $21 put is at $.22 (halfway between bid and ask)and the $22 put is at $.55. If I buy 100 of the $20 puts and sell 30 of the $21 puts, that gets me a $160 credit. (I have used $3k in margin.)

If VXX goes up, I keep the $160 (minus commissions). If it goes down to around $21 (and I know this is not exact), the $20 put will be worth roughly $2,200 (at around $.22) and the $21 put will be worth roughly $1,650. At that point, I would just exit with a $600 profit. Even if I'm off a bit in this scenario, there's still a nice profit.

The way I see it, the only way to lose would be to wait until expiration and VXX is between $20 and $21, and I could lose up to the $3,000. But, the plan is to give it a couple of days. If VXX moves up, I have nothing to worry about, and I just stay in the trade and get the full $160 in credit. If it moves down at all, I'll take a nice little profit and exit way before expiration. If it does nothing, I exit the trade at roughly break even after a couple of days.

So, someone please tell me how that loses more than just a tiny fraction if I only remain in the trade a couple of days. Thank you.

 

[cdcaveman]

You lose the most at the long strike if your in a ratio back spread at expiration...you lost the difference between

 

[Claybie]

Yes, I mentioned that. I won't be going to expiration, though. Just stay in it a couple of days to see what happens, then exit quickly...way before expiration. How to lose then?

 

[guru]

1. You may not be able to buy that ratio spread at credit. You’d have to have some real live trading experience to understand why and how/when your orders may go through. Also, prices may be adjusted as soon as you fill small qty, like 5 ratio spreads, while others may not go through.
Additionally, trading cent-priced options is difficult due to market makers wanting to make a profit and not necessarily fill orders at the mid.
Basically order execution is a topic on its own and requires experience just like studying options in theory.
I actually don’t understand why you’ve studied for so long and now you want to trade fairly large qty, without trying small qty first.

2. When your order does get filled then you’re likely don’t have an advantage and the odds are even or against you. Not necessarily, but usually.
In your case the risk is that VXX will start dropping very fast, which did happen more often in the past. Recently both VIX and VXX were so stretched that they’ve lost most of their ability to go up and now they have higher chance to keep dropping. And in case of VXX, both VIX dropping and VIX futures contango play against you.
But that’s just theory and I wouldn’t bet too much on any specific VXX direction right now, just pointing out potential risk.
When VXX does drop fast overnight or during a day, then the put prices may be adjusted to either cause a loss for you, or not allow you to get out easily - same order execution issues as above.

Anyway, nothing stops you from trying small qty and thus continuing your study with a bit of practice. Otherwise you’ll never know all the answers

 

[Claybie]

Thank you, Guru.
If VXX does start dropping fast, wouldn't having 4 or 5 times more longs more than make up for the shorts? I would think that the faster the drop, the better.
And, it is a larger quantity, but the max loss is just $3k, right? I hope I'm not missing something there.
To tell the truth, I did do the trade. 100 long $20.50 puts at $.04 each and 20 short $21.50 puts at $.17 each. VXX immediately went down, causing the $20.50 puts to be at $.11 and the $21.50 puts to be at $.34. The long puts almost tripled in price, while the shorts doubled. I'll get out in the morning, hopefully around the same price with a nice profit. Isn't that, in theory, what would happen but on a greater level as the price falls further?
I'm really wondering if I just got lucky. LOL.
Thanks again for your time.

 

[guru]

Thank you, Guru.
If VXX does start dropping fast, wouldn't having 4 or 5 times more longs more than make up for the shorts? I would think that the faster the drop, the better.
And, it is a larger quantity, but the max loss is just $3k, right? I hope I'm not missing something there.
To tell the truth, I did do the trade. 100 long $20.50 puts at $.04 each and 20 short $21.50 puts at $.17 each. VXX immediately went down, causing the $20.50 puts to be at $.11 and the $21.50 puts to be at $.34. The long puts almost tripled in price, while the shorts doubled. I'll get out in the morning, hopefully around the same price with a nice profit. Isn't that, in theory, what would happen but on a greater level as the price falls further?
I'm really wondering if I just got lucky. LOL.
Thanks again for your time.

Oh, you’ve originally mentioned ratio spreads while these are back ratios, so my previous answer was for an opposite trade
But either way, I was just trying to point potential risks and issues, while you’re right that this trade can be profitable, although other people may be trading ratio spreads (against you) and make money on smaller move down. So in your case the risk may be on VXX dropping slowly. And in some ways you could’ve got lucky, but in other ways this isn’t a bad trade/strategy.
In the past I was trading more of ratio spreads, so I’d be trading against you, but only if/when option prices would allow me for a wider spread, so that’s when they wouldn’t make sense for you.
Besides some luck, you do seem to understand the potential reward and risk on this trade, so overall I don’t see major flaws in your thinking. You seem to already have a better feel for some stuff than people who’ve been trading just iron condors for years
The rest is just live practice/experience.
Btw, I usually prefer ratios for shorter term while back ratios for longer term & LEAPs (not on VXX). VXX is a unique animal.

 

[taowave]

You are backspread 1x 3.3 and do really well on a fast big move down or below 19.55 on expiration.Sitting still,slow creep up,really slow move down is not your friend.