What Is a Ratio Spread?
A ratio spread is a neutral options strategy in which an investor simultaneously holds an unequal number of long and short or written 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 twice as many short positions as long.
Conceptually, this is similar to a spread strategy in that there are short and long positions of the same options type (put or call) on the same underlying asset. The difference is that the ratio is not one to one.
- A ratio spread involves buying a call or put option that is ATM or OTM, and then selling two (or more) of the same option further OTM.
- Buying and selling calls in this structure is referred to as a call ratio spread.
- Buying and selling puts in this structure is referred to as a put ratio spread.
- There is a high risk if 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.
Understanding the Ratio Spread
Traders use a ratio strategy when they believe the price of the underlying asset won't move much, although depending on the type of ratio spread trade used the trader may be slightly bullish or bearish.
If the trader is slightly bearish they will use a put ratio spread. If they are slightly bullish, they will use a call ratio spread. The ratio is typically two written options for each long option, although a trader could alter this ratio.
A put ratio spread is buying one ATM or OTM put option, while also writing 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 regular spread trade (bull call or bear put, for example), the long options match up with the short options so that a large move in the price of the underlying cannot create a large loss. However, in a ratio spread, there can be two or more times as many short positions as long positions. The long positions can only match with a portion of the short positions leaving the trader with naked or uncovered options for the rest.
For the call ratio spread, a loss occurs if the price makes a large move to the upside, because the trader has sold more positions than they have long.
For a put ratio spread, a loss occurs if the price makes a large move to the downside, once again because the trader has sold more than they are long.
Example of a Ratio Spread Trade in Apple Inc.
Imagine that a trader is interested in placing a call ratio spread on Apple Inc. (AAPL) because they believe the price will stay flat or only marginally rise. The stock is trading at $207 and they decide to use options that expire in two months.
They buy one call with a $210 strike price for $6.25, or $625 ($6.25 x 100 shares).
They sell two calls with a strike price of $215 for $4.35, or $870 ($4.35 x 200 shares).
This gives the trader a net credit of $245. This is their profit if the stock drops or stays below $210, since all the options will expire worthless.
If the stock is trading between $210 and $215 when the options expire, the trader will have a profit on the option position plus the credit.
For example, if the stock is trading at $213, the bought call will be worth $3, or $300, plus the $245 credit (because the sold calls expire worthless), for a profit of $545. The max profit occurs if the stock is at $215.
If the stock rises above $215, the trader is facing a potential loss.
Assume the price of Apple is $225 at the option's expiry.
- The bought call is worth $15 or $150 ($225 - $210 x 100 shares)
- The two sold calls are losing $10 each or $200 ($225 - $215 x 200 shares)
- The trader still has a credit of $245.
In this case, the trader will walk away with a small profit of $195.
If the price goes to $250, the trader is facing a loss.
- The bought call is worth $40 or $400 ($250 -$210 x 100 shares)
- The two sold calls are losing $35 each or $700 ($250 - $215 x 200 shares)
- The trader still has a credit of $245.
The trader now faces a loss of $55, which will get larger the higher the stock price of Apple goes.