Secret 99THE RATIO HEDGE

The ratio hedge can be a high powered option strategy, but it

involves naked writing, so it should only be used by option players

who understand and can tolerate the high risks of naked writing.

The hedging nature of this strategy reduces some of the risk, but

you still face some unlimited risk.

In the 1970’s, I was introduced to ratio hedging by a great

classic book, Beat the Market, written by Edward Thorp, a math

professor, a true pioneer. He beat the casinos and game of blackjack

with a counting strategy revealed in his book, Beat the

Dealer.

In his book, Beat the Market, he introduced a strategy

where you purchased the underlying stock and sold short three

overpriced warrants against the stock. Warrants are like long

term options or Leaps®, so with Leaps® you can create similar

strategies. Such strategies can develop some excellent risk-reward

pictures.

The key to success here is to find some overpriced options.

For example, on April 30 of 2001, Rambus (RMBS) was at 16 and

the January 2003 25 call was 8. Buying the stock and selling two

Jan 03 calls at 8 gives us 16 points in premium, offsetting all the

risk of owning the stock. However, we are naked one option—

above 25.

This strategy has a very wide profit range, from a Rambus

price of 0–50. If Rambus is in that range at January 2003 expiration,

you have a profit. Why? If Rambus is at 25, you have a profit

of 9 points in the stock and of 16 points in option premium for a

total of 25 points to cover your one naked option.

Consequently, only if Rambus were above 50 would you lose

money. Maximum profits of $2500 occur if Rambus is at 25 at

January expiration. Profits can develop during the life of this

trade as the options you have written lose their value.

Not only can you design excellent strategies with long term

options and the stock, you can replace the stock with another

long term option and sometimes create an even better risk-reward

picture. Here you have a ratio spread. Ratio spreads and

hedging are covered in more detail in my book, The Complete

Option Player.

You can test your trade by using a simulator to determine

what is the probability of hitting the stop-loss point or points of

the trade. In the Rambus example, the stop-loss point would be

50, and your probability of hitting 50 would have been 4%, so

there is a 96% chance of breaking even or making a profit. Rambus

closed on January 2003, expiration at 8.05, so your profit

would have been $805.

The ratio hedge can be a high powered option strategy, but it

involves naked writing, so it should only be used by option players

who understand and can tolerate the high risks of naked writing.

The hedging nature of this strategy reduces some of the risk, but

you still face some unlimited risk.

In the 1970’s, I was introduced to ratio hedging by a great

classic book, Beat the Market, written by Edward Thorp, a math

professor, a true pioneer. He beat the casinos and game of blackjack

with a counting strategy revealed in his book, Beat the

Dealer.

In his book, Beat the Market, he introduced a strategy

where you purchased the underlying stock and sold short three

overpriced warrants against the stock. Warrants are like long

term options or Leaps®, so with Leaps® you can create similar

strategies. Such strategies can develop some excellent risk-reward

pictures.

The key to success here is to find some overpriced options.

For example, on April 30 of 2001, Rambus (RMBS) was at 16 and

the January 2003 25 call was 8. Buying the stock and selling two

Jan 03 calls at 8 gives us 16 points in premium, offsetting all the

risk of owning the stock. However, we are naked one option—

above 25.

This strategy has a very wide profit range, from a Rambus

price of 0–50. If Rambus is in that range at January 2003 expiration,

you have a profit. Why? If Rambus is at 25, you have a profit

of 9 points in the stock and of 16 points in option premium for a

total of 25 points to cover your one naked option.

Consequently, only if Rambus were above 50 would you lose

money. Maximum profits of $2500 occur if Rambus is at 25 at

January expiration. Profits can develop during the life of this

trade as the options you have written lose their value.

Not only can you design excellent strategies with long term

options and the stock, you can replace the stock with another

long term option and sometimes create an even better risk-reward

picture. Here you have a ratio spread. Ratio spreads and

hedging are covered in more detail in my book, The Complete

Option Player.

You can test your trade by using a simulator to determine

what is the probability of hitting the stop-loss point or points of

the trade. In the Rambus example, the stop-loss point would be

50, and your probability of hitting 50 would have been 4%, so

there is a 96% chance of breaking even or making a profit. Rambus

closed on January 2003, expiration at 8.05, so your profit

would have been $805.