November 11, 2024
5 mins read
A ratio spread is a popular way to trade options. It's a strategy where you buy and sell options on the same stock, but not in equal numbers. As the name suggests, you use a ratio, commonly selling two options for every one option you buy (a 2:1 ratio).
This is different from a regular spread, where you buy one and sell one. A ratio spread is properly used when you don't expect a stock's price to move very much. It’s a smart way to potentially earn a profit if the market stays calm.
A ratio spread is a strategy traders use when they believe a stock's price will stay within a certain range. It’s a "neutral" strategy, meaning you're not betting on a huge move up or down.
If you are slightly positive (bullish) on a stock, you can use a call ratio spread. If you are slightly negative (bearish), you can use a put ratio spread.
But there's a catch. Because you sell more options than you buy, a big, unexpected price move against you can be risky. If the stock's price moves too far, your losses can become very large. This is why it's considered an advanced strategy.
The strategy differs for call and put options. Both aim to profit from selling options, while buying options provides protection.
Here’s a simple breakdown of how each one works:
Call Ratio Spread (For when you're slightly bullish)
You buy one call option.
You sell two call options at a higher strike price.
The stock price at the strike price of the options you sold maximises profits. Stock price explosions are risky.
Put Ratio Spread (For when you're slightly bearish)
You buy one put option.
You sell two put options at a lower strike price.
If the stock price falls to your options' strike price, you profit most. Sharp stock price drops are risky.
You will need to be familiar with a few fundamental options terms in order to comprehend ratio spreads. To put your mind at ease, they are much easier than they appear!
In the first place, there is the strike price. Simply put, this is the predetermined price at which you have agreed to buy or sell the stock in the options contract that you have.
Following that, you have two different kinds of choices:
Call Option: This gives you the right, but not the obligation, to buy a stock at the strike price before a certain date. When you believe that the price will increase, you make use of calls.
Put Option: This gives you the right, but not the obligation, to sell a stock at the strike price before a certain date. Puts are used when you believe that the price will go down in the future.
Options can be considered "in-the-money" or "out-of-the-money" depending on the circumstances.
In-the-Money (ITM): This means your option is already profitable.
When you have a call option, the current stock price is higher than the strike price you have chosen.
When you have a put option, the current stock price is lower than the strike price you have chosen.
Out-of-the-Money (OTM): This means your option is not yet profitable. You need the stock price to move in your favour.
At the moment, the stock price is lower than the strike price that you have chosen for a call option.
When you have a put option, the current stock price is higher than the strike price you have chosen.
Buy an at-the-money option, also known as an ITM option, and sell two out-of-the-money options when you engage in a ratio spread.
Traders use ratio spreads for a few specific reasons:
To Get Paid Upfront: You can often set up this trade for a "net credit", which means you receive money in your account right away.
To Profit from Calm Markets: The strategy works well when the stock price doesn't move much or moves only slightly in your favour.
To Take Advantage of Time: This strategy benefits from "time decay", as the two options you sold lose their value faster than the single option you bought.
This strategy has a number of advantages:
It may be lucrative in various market conditions – when the stock remains still or moves a little, or even moves slightly against you.
It takes advantage of time running out that favours you; the closer the options approach their expiry date, the better.
You can make it so that there is no start-up fee or even receive payment to open the position.
Your possible gain can be much greater than with your being content with a purchase of a single call or a single put option.
The drawbacks of such a strategy are quite essential to know:
Unlimited Risk: A significant risk is that there is unlimited loss potential. Due to the fact that you sold more options than bought, even a massive price shift against you can result in massive losses.
Margin Required: This will require a margin account to place the trade. This is due to the fact that you are selling options naked (with no stock to cover them).
Higher Commissions: You will incur greater broker fees since you will be doing more than three trades to establish the position.
Limited Maximum Profit: In this case the risk is unlimited, but the maximum amount of profit you can get is limited.
Additional Read: Credit Spread Strategy
Ratio spread is an effective strategy in options that is used by traders when they anticipate that a company will remain in a price range. It is the purchase of one option and the sale of two (or more) at another strike price.
It is a sophisticated manoeuvre, though it may be profitable and even put money into your hand. The key is to clearly realise the possibility of big losses in case the stock takes a huge unanticipated step.
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A ratio spread is an options strategy where an investor holds long and short options in a ratio (commonly 2 :1) on the same underlying.
To profit when the underlying remains stagnant, moves slightly favourably, or strongly unfavourably, often with minimal upfront cost.
Potential for profit in various market directions, benefitting from time-decay, and minimal stop-loss in some cases.
Reduced maximum profit potential, higher commissions, and margin needed when you sell more options than you buy.
In theory yes: large moves of the underlying can cause substantial loss since you’ve sold more options than you’ve bought.
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