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Ratio Spread

Ratio Spread
TradingStrategy and EducationOptions and Derivatives TradingOptions and DerivativesOptions Trading Strategy and Education

What Is a Ratio Spread?

A ratio spread is a neutral options strategy wherein an investor at the same time holds an inconsistent number of long and short or [written](/composing an-option) options. The name comes from the structure of the trade where the number of short positions to long positions has a specific ratio. The most common ratio is two to one, where there are two times however many short positions as long.

Reasonably, this is like a spread strategy in that there are short and long positions of similar options type (put or call) on a similar underlying asset. The difference is that the ratio isn't balanced.

Understanding the Ratio Spread

Traders utilize a ratio strategy when they accept the price of the underlying asset won't move a lot, in spite of the fact that relying upon the type of ratio spread trade utilized the trader might be somewhat bullish or bearish.

On the off chance that the trader is somewhat bearish they will utilize a put ratio spread. In the event that they are somewhat bullish, they will utilize a call ratio spread. The ratio is typically two written options for each long option, albeit a trader could modify this ratio.

A call ratio spread includes buying one at-the-money (ATM) or out-of-the-money (OTM) call option, while likewise selling or composing two call options that are further OTM (higher strike).

A put ratio spread is buying one ATM or OTM put option, while likewise composing two further options that are further OTM (lower strike).

The max profit for the trade is the difference between the long and short strike prices, plus the net credit received (if any).

The drawback is that the potential for loss is theoretically unlimited. In a customary spread trade (bull call or bear put, for instance), the long options match up with the short options so a large move in the price of the underlying can't make a large loss. Nonetheless, in a ratio spread, there can be at least two times however many short positions as long positions. The long positions can match with a portion of the short positions leaving the trader with stripped or uncovered options for the rest.

For the call ratio spread, a loss happens on the off chance that the price takes a large action to the upside in light of the fact that the trader has sold a greater number of positions than they have long.

Once more for a put ratio spread, a loss happens on the off chance that the price takes a large action to the downside, in light of the fact that the trader has sold more than they are long.

Illustration of a Ratio Spread Trade in Apple Inc.

Envision that a trader is keen on putting a call ratio spread on Apple Inc. (AAPL) in light of the fact that they accept the price will remain flat or just barely rise. The stock is trading at $207 and they choose to utilize options that terminate in two months.

  1. They buy one call with a $210 strike price for $6.25 ($625 total = $6.25 x 100 shares).
  2. They sell two calls with a strike price of $215 for $4.35 ($870 total = $4.35 x 200 shares).

This provides the trader with a net credit of $245. This is their profit if the stock drops or stays below $210, since every one of the options will terminate worthless.

On the off chance that the stock is trading somewhere in the range of $210 and $215 when the options terminate, the trader will have a profit on the option position plus the credit. For instance, on the off chance that the stock is trading at $213, the bought call will be worth $3 ($300 plus the $245 credit in light of the fact that the sold calls lapse worthless), for a total profit of $545. The maximum profit happens if the stock settles at $215.

If the stock rises above $215, the trader is facing a likely loss. Accept the price of Apple is $225 at the option's expiry.

  • The long call lapses worth $15, a profit on this leg of $8.75 (15-6.25)
  • The two short calls lapse at $10 each, for a loss of $5.65 x 2 = $11.30 ((10-4.35)x2)
  • The trader's net loss is ($11.30-8.75) x 100 = $255.

On the off chance that the price goes to $250, the trader is facing a larger loss:

  • The long call is worth $40 and the two short calls $35 each = $70-40 = $30, or a $300 loss.

Highlights

  • Buying and selling puts in this structure are alluded to as a put ratio spread.
  • A ratio spread includes buying a call or put option that is ATM or OTM, and afterward selling (at least two) of a similar option further OTM.
  • There is a high risk on the off chance that the price moves outside the strike price of the sold options, while the maximum profit is the difference in strikes plus the net credit received.
  • Buying and selling calls in this structure are alluded to as a call ratio spread.