Which Is Better? Straddle or Ratio?

Writing about the stocks pinned last Friday in a previous post, I mentioned that I sold the 330 straddle. Is this the best way to play the expiration?

Let’s look at some pictures.

Short Straddle

This is the profit and loss chart for selling a straddle, where the 175 call sells for $1.60 and the 175 put sells for $1.20. Total premium received is $2.80. If the stock ends the day at 175, that will be the return on the trade.

Since we receive $2.80 in premium, our break even points are $175 plus $2.80, or $177.80 and $175 – $2.80 or $172.20. Outside of that range, the trade loses money.

Return For A Short Straddle

Ratio Spread

What if instead of selling straddles we put on a ratio spread? That is, when the stock is at $175 we buy one in-the-money call with a $170 strike and sell three at-the-money calls with a strike of $175. The $170 call will cost $5 since it is deep in the money with no time left, and the $175 calls might sell for $1.60 as we saw above. In this case, we receive $4.80 and pay $5 so net we have to pay $0.20.

As you can see below, that is our exposure to the downside. If the stock rallies past $175, we are protected until the stock gets to $177.40. At that point, the 170 call that we are long is worth 7.4 and the three 175 calls we are short are each worth 2.4. So the three of them are worth -7.2 and we paid .2 for the position. So our break even point on the upside is $177.4 and on the downside $170.20.

Return for Ratio Spread

So the ratio spread has a wider range where it is profitable and very little downside risk. On the upside. it loses money faster than the short straddle.

If you wanted the mirror image of this return, $0.20 loss if the stock goes above $177 and the large losses if the stock falls below 170, Then you could buy the 180 for $5 put and sell four 175 puts for $1.20 each. This is more dangerous because we had to sell four puts to take in the same premium we got from three calls.

It all depends on where you think the danger lies.

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