#### Derivatives

Updated on: Dec 04, 2021

Last week, we discussed when to set up ratio spreads, a strategy where you go long on an option strike and short more contracts of another strike of the same expiry on the same underlying. This week we discuss a modification of the ratio spread- the ladder spread.

## Variable strikes

For setting up a call ladder, you should go long on one contract of a lower strike call, short one contract of a higher strike call and short another contract of an even higher strike.

Suppose you go long on one contract of next week 17200 Nifty call (182 points), short one contract of 17300 call (133 points) and short one contract of 17400 call (92 points). You can setup the position for a net credit of 43 points. You can set up a ratio spread (17200/17300) for a net credit of 84 points if you short two contracts of 17300 call.

The ladder spread has relatively lower risk than the ratio spread. The ladder spread will gather losses if the underlying moves above the higher short strike by an amount equal to the maximum pay-off on the position plus net credit (or minus net debit). In this case, the maximum pay-off on the position is 100 points (the difference between the middle strike, 17300, and lower strike, 17200). This is because any gain on the long call if the underlying trades above 17300 at expiry will be offset by losses on the short 17300 call. So, the maximum pay-off on the ladder occurs when the underlying is at the middle strike (17300). Note that the maximum gain is higher in a ratio spread because the net credit is greater.

The break-even on a ladder is 17543 (17400 plus 100 plus 43 points of net credit). This means that the position will not suffer losses when the underlying is between the two short strikes. Note that the break-even for a ratio spread is 17484 (17300 plus maximum pay-off plus net credit, which is 17300 less 17200 plus net credit of 84 points). A higher break-even leads to lower risk on a ladder spread. Of course, the flip side is that your gains will be lower too.

A call ladder can be set up when your view is that the underlying faces resistance at a certain level. In the event the price breaks above this level, it is unlikely to cross the next level. For instance, your view could be that the Nifty index faces resistance at 17268 and the next resistance at 17426. The position works best when the options are closer to expiry, as time decay is faster.

As with ratio spread, you want the underlying to move slowly. This is because gains from time decay on the two short strikes (17300 and 17400) will be greater than the loss from time decay on the long strike (17200). That is why gains could be significant if the underlying moves to 17300 closer to expiry.

Also, the position has negative delta because of two short strikes against one long strike. So, a swift movement in the underlying could hurt the position. That explains why the spread could suffer small losses if the underlying moves to 17300 four days after setting up the position. But these losses could turn into small gains if the implied volatility declines significantly during this period. This is because implied volatility accelerates time decay leading to sizeable gains on the short strikes.

The upshot? You can set up a ladder spread when you expect the underlying to move up slowly, and preferably to the first short strike. You should position the second short strike at a sizeable distance from the first short strike (preferably, one tradable strike for the Nifty Index). Finally, be mindful of the margin requirements for the short strikes when you set up the position.

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Published on December 04, 2021