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August 28, 2009  Fri 12:08 AM CT

Ratio spreads are one way to protect profits without spending too much, but they do come with significant risks.

Put ratio spreads allow traders to have downside protection much like using a bearish put vertical spread. But by selling more options than you buy, you reduce the cost of the trade even further, sometimes creating a credit. This also takes advantage of the volatility skew--lower strikes have higher implied volatility, and therefore higher relative premiums.

The risk with this strategy is the additional short puts, which are naked. This term often causes more concern than necessary, as a naked short put has the same risk as a covered call, which most option traders are comfortable with. Those naked puts also have a margin requirement to hold, so your ability to use this strategy may therefore be limited by your broker.

SPY ChartIn the last episode of CNBC's "Options Action," Dan Nathan discusses a ratio spread in the SPY S&P 500 ETF. He recommends using the December Quarterly 100/90 1x2 put spread against a portfolio of stocks. This entails buying one of the 100 puts and selling two of the 90s. In his example, the 100 puts were bought for $5.30, and the two 90s were sold for a total of $5, or $2.50 each. So this is a net debit of $0.30.

As Nathan says, the trade loses the $0.30 if the market stays put or goes up, but it has good protection down to 900--12 percent lower--and some protection down to 800.

But Mike Khouw and Stacey Gilbert both added warnings on this strategy. Khouw said correctly that "if the market breaks materially lower, you need to be prepared to get long the market if we see a 20 percent pullback." This is because you will be assigned the short puts and will have to buy shares.

Gilbert followed up with the advice that you should know the risks, which should be the first rule of any and all investing. "If we fall out of bed, you will be sad to have had this trade on versus owning a put outright," she said.

This strategy is especially useful when options premiums are high. And while moderator Melissa Lee noted that option premiums have come down and protection is cheaper to buy (which is true), implied volatility is at a significant premium to realized volatility--actually the largest percentage premium I have ever seen.

The only other thing I would add to the discussion is that I typically like to do ratios for a credit, so that the strategy profits at any price unless there is that drop of 20 percent or greater.

(Chart courtesy of tradeMONSTER)

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