In yesterday's edition of Advanced Options, we analyzed the ratio put spread, which allows spot-on option speculators to profit from a stock's stagnation or moderate move lower. In today's column, we're on a mission to dissect a theoretical ratio put spread on mine-protected vehicle mogul Force Protection, Inc. (FRPT: sentiment, chart, options).
Reviewing the Ratio Put Spread
Before we begin, let's take a fresh look at the ratio put spread. The strategy is generally utilized by investors expecting little volatility or a slight decline from the stock in the near term. Before initiating the spread, the trader should have a "bottom" in mind typically the site of technical support as a significant journey into the red could result in hefty losses on the play.
To implement the ratio put spread, the investor would buy an at- or slightly in-the-money put, while simultaneously selling two (or more) out-of-the-money puts with the same expiration. The written put strike should coincide with the aforementioned "bottom," as the spread strategist needs the underlying security to finish at this strike at expiration to achieve the maximum potential profit.
Depending on the price of the puts at initiation, the ratio put spread can be established for either a net debit or a net credit. In either situation, the investor stands to lose a significant amount of capital following a notable decline past the lower breakeven rail. In the wake of a sudden surge higher, the spreads established for a net credit can still bank a small profit, while those initiated for a net debit will surrender the initial premium paid.
(Don't forget to include any margin requirements, brokerage fees or commission costs in your calculations.)
Scouting for Stocks
So, why did we target defense diva Force Protection for our hypothetical ratio put spread? Most notably, because the shares of FRPT have remained range-bound during the past few months, with evident resistance and more importantly support levels in place. Plus, the company isn't slated to step into the earnings confessional again until November, meaning we can hone in on front-month options without an earnings-related catalyst sparking a significant move on the charts.
Since July, FRPT has remained inhibited between support at its 20-month moving average and resistance at its 10-month trendline. The former of these moving averages currently lingering in the $5 region is reinforced by its 100-month brethren. This long-term trendline played the part of resistance in 2008, and contained the stock's pullback in March 2009. As such, this double-barreled support at the $5 level makes a case for our technical "bottom."
On that same note, the aforementioned 10-month moving average currently dawdling in the $6.50 neighborhood has an ally in its 60-month cohort, which capped FRPT's rally attempts earlier this year. This duo of moving averages could remain bulletproof on the charts, pressuring the equity lower in the near term.
With firm parameters and a potential "bottom" in mind, FRPT is a prime candidate for our theoretical ratio put spread.
Patrolling the Play
To implement our ratio put spread, we're first going to buy the in-the-money October 7.50 put, which was last asked at $1.40. Since FRPT's technical "bottom" resides at the $5 level, we're going to simultaneously sell two October 5 puts, which were last bid at $0.05 each, or $0.10 total. Since the premium paid for the higher-strike put outweighs the premium received from the two lower-strike puts, our position was established for a net debit of $1.30 ([$1.40 x 1 contract] [$0.05 x 2 contracts]).
To achieve the maximum reward of $1.20 ([7.50 5] - $1.30), we need the shares of FRPT to finish at the $5 level when front-month options expire on Friday, Oct. 16. If this occurs, both of our written puts would expire worthless, allowing us to pocket the initial premium of $0.10, while our purchased October 7.50 put would be in the money.
By implementing the ratio put spread for a net debit, we're subjected to two breakeven rails (if we'd established the spread for a credit, we'd have to contend with only one breakeven level). The lower breakeven rail rests at $3.70 (5 - $1.30), while the upper breakeven rail stands at $6.20 (7.50 - $1.30).
Should FRPT rocket past the $6.20 level before expiration, we'd be forced to forfeit our initial net debit of $1.30. On the other hand, a breach of the lower breakeven rail could be devastating, with a maximum potential loss of a hearty $6.30 (5 + $1.30), should the stock unexpectedly drop to zero.
Before the Battle
In conclusion, investors embarking on this option-trading mission should target stocks with a neutral to moderately bearish backdrop, but with a specific "bottom" in mind. As such, spread strategists should prowl for stocks with potential support on the charts, such as a critical moving average, a heavy amount of near-term put open interest, or a region that's acted as a foothold in the past.
Finally, considering the ratio put spread requires accuracy in order to profit, and since the potential losses of this option play eclipse the potential rewards, only seasoned option speculators with a risk appetite of steel need apply.
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