What is Ratio Spread | Purpose, Work and Strategy

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Introduction:

A ratio spread is a neutral option strategy where an investor holds both long and short options without needing them to be equal in number. 

The ratio spread is named so because there is a specific ratio, most commonly 2:1, that exists between the short and long positions correspondingly. 

A ratio spread strategy is similar to a spread position as in both these trades long and short positions exist of the same option type i.e. call option and put option and of the same underlying asset. However, in a spread position, the ratio is 1:1, unlike the ratio spread. 

What is the Ratio Spread Options Strategy?

An investor or trader uses a ratio spread option strategy when the underlying asset's price won’t see any significant change. 

If an investor is slightly bearish, then they will use the put ratio spread and if an investor is slightly bullish, they will use the call ratio spread. Investors can also choose to alter the 2:1 ratio of the strategy if they want.

The loss potential in a ratio spread is unlimited, in theory. Unlike a regular spread with a 1:1 ratio, a large price move on the underlying will not create a huge loss. However, the loss potential can be high in a ratio options strategy with a 2:1 ratio.  

How Does Ratio Spread Work?

Here is a breakdown of how both the call option and put option ratio spread work:

Call Ratio Spread:

  • Here, investors buy either one in-the-money (ITM) or one out-of-the-money (OTM) call option while they sell or write two higher-stake OTM call options.
  • When the price of the underlying swings upwards significantly, a loss is incurred as the trader has sold more positions than they have long.

Put Ratio Spread:

  • Investors buy one ITM or OTM put option and sell or write two lower-stake OTM.
  • Here a loss is incurred when the price of the underlying moves significantly downward since the trader again has sold more than they are long

Terms Associated with Ratio Spread Options

When trying to understand what a ratio spread is, it is important to understand all the terms associated with this strategy. Here is a list:

  • In-the-money option or ITM

The ITM option is when the value of the underlying asset or security is higher than its strike price. Such an option has intrinsic value and presents itself as a profitable opportunity for an investor. When associated with a call option and put option, an investor can look to gain in two ways. 

An in-the-money call option enables the option holder to buy an asset or security below its current market price. An in-the-money put option helps the option holder sell the asset or security above its market price. 

  • Out-Of-The-Money Option or OTM

The OTM option is when the price of the underlying asset or security is lower than its strike price. The OTM option has no intrinsic value but it does have an extrinsic value. If the option holder wants to exercise the OTM option, they would end up either overpaying or getting underpaid for an asset.  

An OTM call option is when the underlying asset value is below the strike price of the call whereas an OTM put option has a lower strike price than the asset’s underlying market price. 

  • Strike Price:

The initial price at which the options contract starts is the strike price. This is also called a predetermined price of the options contract.

  • Call Option:

When an investor can buy an asset or security at a fixed price and on a fixed date, it is a call option. 

  • Put Option:

When an investor can sell a security or asset at a fixed price and on a fixed date, it is a put option.

What is the purpose of ratio spreads?

Below is a list of the various purposes of ratio spreads:

  • There is no need for upfront payment in ratio spreads. 
  • Helps convert debit horizontal, vertical, and diagonal into credit spread positions thus keeping them profitable even if the stock takes a negative turn
  • If used for net credit, ratio spreads became beneficial when:
  1. The underlying stock remains stagnant
  2. The underlying stock moves slightly in a favourable direction
  3.  The underlying stock moves strongly in an unfavourable direction
  • It helps create an unrestricted potential for profit even if there is a volatile credit position of options, making it more sophisticated than other options trading strategies.  

Advantages of Ratio Spreads

Here are some of the advantages of ratio spreads:

  • It helps generate profits from many directions
  • Has the potential to generate profits notwithstanding the increase or decrease in the price of the underlying asset or security
  • A ratio spread is beneficial against time value decay, where time decay refers to the change rate in the price of an option as its expiration date nears.
  • In a ratio spread, the stop loss is also minimal
  • The ratio spread is also capable of outperforming a single call across time. 

Disadvantages of Ratio Spreads

Here is a list of the disadvantages of ratio spreads:

  • Ratio spreads can alter the profit potential of both the call option and put option spreads from unlimited to limited
  • If additional trades are to be done, they will always call for higher commissions in a ratio spread
  • The possibility of incurring maximum profit gets reduced when a ratio spread puts on the credit options trading positions. 
  • A margin is mandatory when investors want to short more options when compared to purchasing the same type of options

Conclusion

A ratio spread is undoubtedly a crucial options trading strategy. The basic concept of a ratio spread consists of traders buying and selling options of the same underlying asset. These options have the same expiry details at different strike prices. The benefit of an option trading strategy is that the potential for profits always exists, regardless of which direction the value of the asset travels.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

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