Ratio Spread – Options Trading Strategy You Must Know
The ratio spread is an options trading strategy which involves making short and long options positions. It can be quite advantageous when used correctly. However, investors should always take different risks and rewards before using this strategy.
This article helps you understand how ratio spreads work, common terms associated with ratio spread, its types, examples and more. Read on!
What is the Ratio Spread Options Strategy?
As mentioned already, ratio spread is a neutral strategy for options trading. Here, an options trader carries long (purchased) and short (written) options contracts in unequal numbers. He or she always holds contracts in a specific ratio, which is a fundamental concept underlining the ratio spread options strategy.
Ratio spread is called so because of trade structure, which carries a specific ratio of short positions and long positions. Note that the most common ratio happens to be 2:1. It indicates the sale of twice as many short options against long options.
Let us use an example to understand this strategy further. Suppose a trader holds two long contracts. In such a situation, the number of short contracts that he will need to hold is four. Thus, he will achieve a ratio of 2:1.
The ratio spread strategy is similar to other spreads because it uses similar options with the same underlying assets and expiry dates. However, the main point of difference lies in their ratios, which are never supposed to be 1:1 in ratio spreads, unlike various other spreads.
How Does Ratio Spread Work?
Ratio spread is a high-probability-neutral strategy in options trading. It involves purchasing a certain number of options contracts and selling more such options of the same stock at a certain expiry date and strike price. A certain ratio is followed (most popularly, two shorts to one long) for such ratio spread strategies.
An options trader undertakes this strategy when he believes that the underlying stock will experience minimum volatility in the coming days.
Terms Associated with Ratio Spread Options
Listed below are important terms:
• In-the-money Option (ITM)
When the price of underlying assets or securities is more than their strike price, they are ITM options.
• Out-of-the-money Option (OTM)
When an underlying asset’s price is lower than the strike price, it is known as an OTM option.
• Strike Price
This is the initial price of an options contract. People also refer to strike price as a predetermined price.
• Call Option
This is an option where one gets the right to buy certain security at a certain price and date.
• Put Option
This is an option where the contract buyer gets the right to sell a certain security at a certain price and date.
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Types of Ratio Spreads
Traders can primarily use two types of spreads within the broad framework of the ratio spread strategy. These are call ratio spread and put ratio spread. Let us look at their details:
• Call Ratio Spread
According to financial experts, call ratio spread is a neutral options trading strategy ideal for a moderately bullish outlook. Here, traders purchase call options at a lower strike price and sell off many more options at a higher strike price.
Note that the options they sell off are of the same underlying stock. In addition, the number of contracts that traders purchase and sell remains in a particular ratio. For example, a trader can create a call ratio spread for a 2:1 ratio by purchasing one ‘in-the-money’ call option and selling two ‘out-of-the-money’ call options.
• Put Ratio Spread
This is a premium neutral and bearish strategy where traders purchase put options at a higher strike price and sell a high number of options at a lower strike price of the same underlying stock. Losses occur if the price makes a large downside move.
A trader can create a put ratio spread by purchasing, at the same time, one ‘in-the-money’ put option and selling two ‘out-of-the-money’ put options of the same underlying stock.
What is the Purpose of Ratio Spreads?
Listed below are various purposes of ratio spreads:
- Ratio spreads prevent the need for upfront payments. This strategy can also convert debit horizontal, vertical or diagonal spread positions into credit spread positions for options trading. This enables the positions to remain financially beneficial even if the direction of a stock takes a negative turn.
- When a person uses ratio spread for a net credit, it becomes beneficial in three different ways—(i) First, when underlying stock remains stagnant, (ii) second, when the underlying stock slightly moves towards the favourable direction and (iii) finally, when the underlying stock strongly moves slightly towards an unfavourable position. Ratio spread shields the directional weaknesses in horizontal, vertical and diagonal spreads.
- The purpose of ratio back spread is to create unrestricted profit potential from a volatile credit position of options, which makes it a more sophisticated strategy than other options trading strategies.
Example of a Ratio Spread Trade
Let us use an example to understand ratio spread trade better:
Suppose a trader places a call ratio spread in a company’s stock which is trading at Rs.200. It has an expiration date of 3 months. In addition, it has 100 shares. Its structure will be as follows:
- First, the trader has to purchase a call option with Rs.220 strike price and Rs.8 premium. (Total Rs.800 as 8×100=800)
- Next, the trader has to sell two calls with a strike price of Rs.240 and Rs.6 premium (Total Rs.1200 as 6×200)
From this transaction, the trader will earn a net credit of Rs.400 (1200 – 800). If the stock price dips and remains below Rs.220, Rs.400 will be the highest profit he can earn. If this stock trades between Rs.220 and Rs.240 during expiry, he can earn profits through options position and a net credit of the first premium.
Note that the trader can earn a maximum profit if the stock price is Rs.240 during expiry. But, if the stock price exceeds Rs.240, the trader has a chance of losing with each point of increase.
How Are Spreads Structured?
The trading strategy of ratio spread uses the combination of long and short options of the same type. Usually, the combinations are in varying ratios.
One must note that there is no randomly chosen combination of strikes. Generally, it takes into account the workings of the delta of the options that are there in the spread.
A put ratio spread contains a long put and multiple OTM short puts. Furthermore, it consists of a long delta bias that can benefit from the underlying asset moving higher or a bit lower compared to the strikes of short options.
On the other hand, a call ratio spread contains a long call and multiple OTM short calls. Moreover, it also has a short delta bias which benefits from the underlying asset moving lower or a bit higher compared to the strikes of short options.
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Advantages of Ratio Spreads
Listed below are some advantages of using ratio spreads:
- It is capable of generating profits from various directions.
- In addition, ratio spreads carry the potential to generate profits irrespective of the increase or decrease in the value of the underlying assets.
- Ratio spread provides a lot of benefits against time value decay. In addition, the stop loss is minimal and can outperform a single call across time. Experts have defined time decay as the change rate in the value of the price of an option as it reaches expiration.
Disadvantages of Ratio Spreads
Given below are its disadvantages:
- This strategy alters the profit potential of call or put spreads from unlimited to limited
- When it puts on the credit options trading positions, it reduces the possibility of maximum profit
- Margin is a mandatory requirement when one decides to short more options than when a person purchases options of the same type
- Additional trades call for higher commissions
Final Word
Ratio spread is an important strategy in options trading. As per its underlying concept, traders buy and sell a certain number of options of the same underlying stock and the same expiry details at various strike prices. This strategy of options trading carries the potential to generate profits regardless of the movement in the value of underlying assets.
FAQs
Ans: The ideal time to initiate a call ratio spread is when the options trader believes that the underlying asset’s price will slightly increase in the coming days. Call ratio spread is a strategy that helps reduce the costs for the premium amount that has been paid. In addition, in special situations, one can also receive upfront credit.
Ans: Traders must note that call ratio spread is associated with unlimited risks, especially when the underlying asset achieves a higher breakeven. Therefore, economic experts recommend strictly following stop losses to limit losses.
Ans: Traders must carefully use ratio spread, a neutral options trading strategy, to earn maximum profits. Generally, when traders believe the price of the underlying asset will rise moderately, they can use ratio spread.
However, people need to remember that as this is a complicated trading strategy, they need to learn its usage very well before successful implementation.
Ans: A debit spread is an options trading strategy that involves purchasing and selling options of the same type but different strike prices simultaneously at the same time. This transaction will result in a debit to an investor’s account.
Ans: Experts have defined ‘put back spread’ as a bearish strategy involving selling off options at a higher strike and purchasing more options at a lower strike. Note that the underlying asset has to be the same. It is a limited risk and unlimited profit strategy which a trader uses when he thinks that the price of underlying assets will drop significantly.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
