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!
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.
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.
Listed below are important terms:
When the price of underlying assets or securities is more than their strike price, they are ITM options.
When an underlying asset’s price is lower than the strike price, it is known as an OTM option.
This is the initial price of an options contract. People also refer to strike price as a predetermined price.
This is an option where one gets the right to buy certain security at a certain price and date.
This is an option where the contract buyer gets the right to sell a certain security at a certain price and date.
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:
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.
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.
Listed below are various purposes of ratio spreads:
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:
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.
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.
Listed below are some advantages of using ratio spreads:
Given below are its disadvantages:
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.
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.
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