Understanding
Stock Options Trading
and Technical Analysis Basics

Call Ratio Spread

Ratio Spread options are a variation of the vertical spread (an option spread using the same option expiration date), and are sometimes known as ratio vertical spreads. It is a neutral strategy designed to take advantage of a non-volatile stock. As the name implies, the difference is that it isn't a 1-for-1 spread where 1 option is bought and another option is sold; it is set up by opening a ratio of options sold to options bought. It can be any ratio, but we will focus on ratio spreads created using a 2:1 ratio with 2 options sold to 1 option bought.

The Call Ratio Spread is a ratio spread that is created using call options. 1 In-the-Money (ITM) call option is bought and 2 At-the-Money (ATM) call options are sold. Since this means you are selling more options than you are buying, you are essentially selling or writing these excess options naked or uncovered. There is an inherent risk in this (as will be explained later), and some options brokers will not allow you to do this unless you can demonstrate enough trading experience.

Call Ratio Spread - Buy 1 ITM Call, Sell 2 ATM Calls
Call Ratio Spread - Buy 1 ITM Call, Sell 2 ATM Calls

One of the main benefits of this strategy is that the initial cost of opening the position is close to zero, and may even earn you a small income. Since the ITM call option costs more than the ATM call option, the cost of buying 1 ITM call will be roughly offset by selling 2 ATM calls. Because you could earn an initial income with this strategy, it is also sometimes known as a ratio credit spread.

At expiry, if the underlying stock price falls below the ITM call strike price, all the options expire worthless and no additional profit or loss is made. If the stock price ends up above the ITM strike price, you will be able to sell the ITM call option you previously bought. Your income will increase the closer you get to the ATM call options' strike price. Once the stock price goes beyond the ATM calls' strike price, you will now need to buy back the 2 ATM calls that you previously sold. Since you need to buy back 2 options while only selling 1 option, this will end up creating a larger and larger loss the higher the underlying stock price rises.

You therefore reach your maximum profit if the stock ends up at the ATM calls' strike price, where you can sell the ITM call for the maximum amount while still letting the ATM calls expire worthless. However, the higher the stock price rises, the greater your loss. The Call Ratio Spread is therefore a neutral strategy suitable for non-volatile stocks, with limited to no losses if the stock price falls, but with unlimited losses if the stock price rises.

Summary:

Call Ratio Spread options can be opened with very little initial outlay, and involve buying 1 ITM call and selling 2 ATM calls. It is a neutral strategy for low volatility stocks. You reach maximum profit if the stock price doesn't move. You incur unlimited losses if the stock price climbs too high.

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

Ratio Spreads 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 the Ratio Spread 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.