Understanding
Stock Options Trading
and Technical Analysis Basics

Put Ratio Spread

Ratio Spread trading is a variation of the vertical spread (an option spread using the same option expiration date). It is a neutral strategy designed to take advantage of a non-volatile stock. As the name implies, ratio spread trading is set up by opening a ratio of options sold to options bought. It can be any ratio, but our example here will focus on ratio spreads created using a 2:1 ratio with 2 options sold to 1 option bought.

The Put Ratio Spread has a neutral profit and risk profile, and is constructed using put options. 1 In-the-Money (ITM) put option is bought and 2 At-the-Money (ATM) put options are sold. The initial cost of this strategy is close to zero, and may even earn a small income. This is due to the cost of buying 1 ITM option being very close to the income made from selling 2 ATM options.

The Put Ratio Spread will not make any additional profit or loss if the underlying stock price ends up higher than the ITM put option's strike price (due to all the put options expiring worthless). Once the stock price falls below the ITM strike price, you can earn profit from selling the ITM put option you bought earlier. This profit will keep increasing the lower the stock price goes.

However, once the stock price drops below the ATM put options' strike price, the profit will start to decrease very quickly. From this point on, the ATM put options will no longer expire worthless and must be bought back. Since you will need to buy back 2 options while selling only 1 option, you will incur greater and greater losses the lower the stock price gets.

Put Ratio Spread - Sell 2 ATM Puts, Buy 1 ITM Put
Put Ratio Spread - Sell 2 ATM Puts, Buy 1 ITM Put

The Put Ratio Spread therefore has a neutral profit profile. It achieves maximum profit if the underlying stock price ends up at the ATM put strike price where you can sell the ITM put option while letting the ATM put options expire worthless. Volatility in the upward direction does not produce any profit or loss, while downward volatility will result in unlimited losses. In that sense, while the Put Ratio Spread is geared towards neutral non-volatile stocks, it slightly favors the bullish direction.

Summary:

Put Ratio Spread trading has very little initial costs, and the position is opened by buying 1 ITM put and selling 2 ATM puts. It is ideal for neutral non-volatile stocks. Maximum profit is reached if the stock price doesn't move. Unlimited losses are incurred if the stock price falls too low.

A Call Ratio Spread has a similar neutral profit and risk profile to the Put Ratio Spread, but is constructed using call options instead of put options.

Both types of Ratio Spread strategies are ideal for neutral non-volatile stocks, and are similar to other option strategies such as the Butterfly and Iron Condor. The key difference is that Ratio Spread trading has a chance of incurring unlimited losses if the underlying stock is too volatile. However, this risk is offset by the fact that Ratio Spreads are constructed using less options and will therefore cost less commissions to open and close the positions.