The ratio spread trading strategy is a variation of the vertical spread strategy which involves an option spread using the same expiration date for multiple strategies. This is a neutral strategy that is useful when it comes to taking advantage of an underlying stock that has an extremely low amount of volatility. Much as the name implies, this strategy works by setting up an opening at a ratio of options sold to the number of options bought. The specific ratio can vary based on your personal needs, though the examples outlined below will deal with a 2 to 1 ratio of options sold to options bought.
Ratio spread strategies are an ideal companion when it comes to stocks that are certified non-volatile. Broadly, they are similar to trading strategies such as the butterfly or the iron condor with one major difference. Specifically, ratio spreads have a greater chance of loss if the underlying stock ends up being too volatile. This risk is then offset due to the fact that these spreads are built using fewer options total which means there will be fewer commission costs related to opening and closing the positions.
Put ratio spread
The put ratio spread has a neutral risk and profit profile that is constructed, unsurprisingly, by using put options. To put it into play you are going to want to purchase one put option that is in the money and sell two more put options that are current for the money. This strategy can be put into play for practically no upfront cost and may actually end up generating a small amount of profit. This occurs because the cost of the in the money option is going to be very close to, or less than, the amount made when selling the two at the money options.
It is important to keep in mind that the put ratio spread will not generate extra losses or profit if the underlying stock price rises above the in the money price of the first put options strike price. This is the case because if this occurs then all of the put options will expire worthlessly. After the price of the underlying stock dips below the in the money strike price, you will be able to earn a profit by selling the in the money option that was previously purchased. This profit will continue to increase as the price of the underlying stock continues to dip.
However, it is also important to keep in mind that once the price of the underlying stock drops below the at the money strike price of the puts you are selling the potential for profit will start to decrease rapidly. At this point, the at the money put options will no longer expire as worthless and must be bought back to prevent additional losses. As this will require you to purchase 2 options while only selling 1 the losses will continue to mount as the price of the underlying stock continues to drop.
As such, the put ratio spread can be thought to have a profit profile that is neutral with a slightly bullish tinge. It can achieve maximum profit only if the underlying stock price ends at the at the money put strike price. When this occurs, you can then sell the in the money put option while letting the other pair expire. Upward volatility will not generate additional profits or losses as all three puts will be affected equally and cancel out the greater profits. Meanwhile, losses due to downward volatility are going to be practically limitless. As such, this strategy should only be used with stocks that are neutral and non-volatile, and you are confident that they will stay this way until the strategy is complete.
Call ratio spread
The call ratio spread strategy uses call options in a variation of the standard vertical spread that uses a ratio of call options, most commonly in a 2:1 format. This is a neutral strategy that is best used on stocks that show a low degree of volatility. To utilize this strategy, you are going to want to purchase one in the money call option while selling a pair of call options that are at the money. As you are selling a greater number of options than you are purchasing, it is important to keep in mind that the additional options are going to be uncovered which makes the potential for loss significant if you choose poorly.
Due to this fact, the call ratio spread is considered a neutral strategy that is only suitable for non-volatile stocks. It creates a scenario where a falling stock price generates little to no losses while gains create the potential for unlimited losses. Be careful when using them and ensure that there are no news releases forthcoming as this can easily change a low-volatility stock into one with a high level of volatility.
This creates an extra layer of inherent risk with this strategy, and certain brokers will not let you go through with it until you have proved yourself experienced. However, this risk is mitigated to some degree as you have the possibility of earning a profit through the sale as the in the money call option will always be offset by selling the at the money options.
Once the expiration date arrives, if the price of the underlying stock drops below the strike price then all of the options are going to expire without making a profit, though they won’t cost you anything extra either. If the underlying stock price ends up being greater than the in the money strike price, then you will be able to sell the option that is in the money for a profit. The amount of income that is generated by this sale will increase the closer the price is to the at the money price of the other options you purchased.
If the price of the underlying stock ends up being greater than the at the money strike price, then you will need to buy back the at the money calls to avoid losing money. As you will need to buy back more options than you are selling this will create an ever-increasing potential for loss. As such, the maximum way to generate a profit with this strategy will see the price of the underlying stock finishing up exactly at the at the money strike price. This will allow you to sell the in the money option for the greatest amount possible while still allowing the at the money calls to expire worthlessly.