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 positions. 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 with the same expiration date. The difference is that the ratio is not one to one.
BREAKING DOWN Ratio Spread
Traders use a ratio strategy when they not only believe the price of the underlying asset will not move much before expiration but more convinced it will play out the way that traders using a simple spread trade. The benefit is that it also uses the extra short positions to further finance the long position, theoretically reducing the cost of the strategy and possibly resulting in a net credit.
The drawback, however, is that the potential for loss is theoretically unlimited. In a regular spread trade (bull call, bear call, bull put and bear put), 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, 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.
Example of a Ratio Trade
A simple 2:1 ratio spread using calls could involve the purchase of one call option with a strike price of $45 for $300 and writing two call options with a strike price of $50 for a $150 each or $300 total. The net cost to this trade, before commissions, would be zero. However, with three options involved, commissions must be considered.
This would allow the investor to capture a gain on a small upward move in the underlying stock's price with maximum profit achieved when the underlying is at the higher strike price at expiration. The two short options expire worthless and the long option is five points in the money and valued at $400.
However, any move past the higher strike price ($50) of the written options will cause this position to lose value. Theoretically, an extremely large increase in the underlying stock's price can cause an unlimited loss to the investor due to the extra short call.
Of course, for a put ratio spread, the parameters are mirror images with one long put at the higher strike price and two (or more) short puts at the lower strike price. The lower the price of the underlying asset below the lower strike price at expiration, the worse the loss becomes.