Ratio Spread

A ratio spread is a neutral options trading strategy that involves buying multiple options of a particular financial instrument and then selling more options of the same security and expiration date at another strike price. Traders choose this strategy when they think the underlying financial instrument's price won't move much.

This strategy's name comes from the trade's structure, where the number of short and long positions has a particular ratio. The most common ratio is 2:1. In other words, the number of short positions is twice that of long positions. This trading approach is similar to the spread strategy. However, a crucial difference is that the ratio is not 1:1.

• The ratio spread options strategy involves the simultaneous buying and selling of an unequal number of options of a specific security with different strike prices but the same expiry date. Commonly, these spreads have two short options and one long option.
• Traders using a back spread expect the underlying security's price to move significantly soon.
• The maximum profit earned by traders using this strategy would be the difference between the strike prices plus the amount of net credit received (if any).
• Traders using a put ratio spread incur losses when the underlying asset's price drops significantly.

The ratio spread options strategy involves traders holding an unequal number of short, long, and written options simultaneously. Typically, individuals opt for this strategy when they think the underlying financial asset won't be subject to significant volatility in the near term. However, traders may be somewhat bearish or bullish depending on the ratio spread type.

When traders are slightly optimistic, they choose call ratio spread. It involves purchasing one out-of-the-money (OTM) or at-the-money (ATM) call option and simultaneously writing or selling two further OTM call options.

On the other hand, individuals use a put ratio spread when they are a bit bearish. This strategy involves buying an OTM or ATM put option and simultaneously writing two further OTM put options. Individuals can find out the maximum profit they can earn executing this trade by calculating the difference between the long and short options and then adding the result to the net credit received (if applicable).

One of the main disadvantages of this strategy is that the risk is unlimited from a theoretical standpoint. In the case of a regular spread trade, for instance, a bear call or bear put, short and long options match up to ensure that a significant movement in the price of the underlying financial instrument does not lead to a substantial loss. That said, in the case of a ratio spread, the number of short positions is at least twice the number of long positions. Thus, the long positions can only match up with a portion of the short positions, thus leaving the trader with uncovered or naked options for the remaining long positions.

Individuals incur a loss in the case of a call ratio spread trade if the price makes a significant upside movement. This happens because the traders have more short positions than long. For the same reason, in the case of a put ratio spread, a trader incurs a loss when there is a significant downside movement in the underlying financial instrument's price.

Let us look a few ratio spread examples to understand the concept better.

Example #1

Suppose ABC stock is trading at $100 per share. David, a trader, wants to place a call ratio spread on the security as he believes its price will marginally rise or remain flat in the near term. Therefore, he utilizes options contracts that expire in two months.

David purchases a call option with a strike price of $103 for $7, i.e., $700 in total ($7 x 100) to execute the strategy. Simultaneously, he purchases two call options with a strike price of $108 for $4, i.e., $800 in total ($8 x 200). As a result, he gets a net credit of $100. This will be his profit if the security's price stays below $103, as every option will expire worthlessly. However, if the stock trades between $103 and $108 at the expiry, David will earn net credit and a profit on the position.

For instance, if the stock trades at $106, the call he purchased will be worth $3 ($300 + $100 net credit as the sold call will expire worthlessly), for an overall profit of $545. David can earn a maximum profit if the underlying stock's price settles at $108.

David will potentially lose if ABC's stock price surges over $108. To understand this, let us assume that the stock trades at $118 at the time of the option's expiry. To understand this, let us assume that the stock trades at $118 at the time of the option's expiry.

• The long call's worth at the expiry will be $15. Therefore, David will earn a profit of $8 ($15 - $7).
• Two short calls will expire at $10, thus generating a loss of $12
• The net loss incurred by the trader will be $400, i.e., ($12- $8) x 100

Example #2

Let us look at the following call ratio spread payoff graph to get a clear idea about the concept.

Suppose Stock ABC trades at $104. Jack, a trader, could enter with a couple of short calls at $110 and a long call at #100. Let us assume that a $2 credit is received. In case the security closes at the $110-mark, Jack realizes the highest profit potential. Note that $1,200 is the maximum amount that he can make on that trade. While the short calls would be subject to worthless expiration, he can offload the long call for $10, i.e., the spread’s width ($10), plus the initial credit of $2. In case Stock ABC closes at $122 upon expiration, short calls would cost $24 combined to exit. However, the long call would be worth $22.

Since the position got $2 at the trade’s entry, the position would break-even at the time of expiry if the underlying asset trades at $122. In case the Stock ABC closes under $100, every option would expire worthless while the original $200 credit would remain. In case Stock ABC closes over $122, there will not be any limit on the maximum potential loss.  

Individuals new to the world of derivatives trading are often unfamiliar with ratio spread, back spread, and vertical spread. Before they engage in options trading, they must understand the critical differences between these three concepts. Without understanding the distinct characteristics, they will be unable to understand which strategy best suits their requirements. So, the following table highlights the main differences.

This article has been a guide to what Is Ratio Spread Option Strategy. Here, we explain it with an example and compare it with back and vertical spreads. You may also find some useful articles here -

• Debit Spread
• Calendar Spread
• Bid-Ask Spread