Understanding
Stock Options Trading
and Technical Analysis Basics

Ratio Spread Strategy

The Ratio Spread strategy 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, 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 this article 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 individual components

Call Ratio Spread composite

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.

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 strategy 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.

Easy-speak A Call Ratio Spread is a strategy with very little initial outlay that involves 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. 1 ITM put option is bought and 2 ATM put options are sold. As mentioned above, a ratio spread can be constructed using various ratios, but a 2:1 ratio of 2 options sold to 1 option bought is used in this article. 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 individual components

Put Ratio Spread composite

The Put Ratio Spread therefore has a similar profit profile to the Call Ratio Spread. 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 both the Put Ratio Spread and Call Ratio Spread are geared towards neutral non-volatile stocks, the Put Ratio Spread slightly favors the bullish direction while the Call Ratio Spread has more protection in bearish situations.

Easy-speak A Put Ratio Spread has very little initial costs, and is created 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.

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 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.

Other Topics in this Guide

Bullish Strategies Bearish Strategies Neutral Non-Volatile Strategies Neutral Volatile Strategies

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