The put ratio spread is a neutral strategy in options trading that involves buying a number of put options and selling more put options of the same underlying stock and expiration date at a different strike price. It is a limited profit, unlimited risk options trading strategy that is taken when the options trader thinks that the underlying stock will experience little volatility in the near term.
|Put Ratio Spread Construction|
|Buy 1 ITM Put|
Sell 2 OTM Puts
A 2:1 put ratio spread can be implemented by buying a number of puts at a higher strike and selling twice the number of puts at a lower strike.
Maximum gain for the put ratio spread is limited and is made when the underlying stock price at expiration is at the strike price of the options sold. At this price, both the written puts expire worthless while the long put expires in the money. Maximum profit is then equal to the intrinsic value of the long put plus or minus any credit or debit taken when putting on the spread.
The formula for calculating maximum profit is given below:
Loss occurs when the underlying stock price experiences a sharp decline and drop below the breakeven point at expiration. There is no limit to the maximum possible loss when implementing the put ratio spread.
Any risk to the upside for the put ratio spread is limited to the debit taken to put on the spread (if any). There may even be a profit if a credit is received when putting on the spread.
The formula for calculating loss is given below:
There are 2 break-even points for the put ratio spread position. The breakeven points can be calculated using the following formulae.
Suppose XYZ stock is trading at $48 in June. An options trader executes a 2:1 ratio put spread strategy by buying a JUL 50 put for $400 and selling two JUL 45 puts for $200 each. The net debit/credit taken to enter the trade is zero.
On expiration in July, if XYZ stock is trading at $45, both the JUL 45 puts expire worthless while the long JUL 50 put expires in the money with $500 in intrinsic value. Selling or exercising this long put will give the options trader his maximum profit of $500.
If XYZ stock price drops and is trading at $40 on expiration in July, all the options will expire in the money but because the trader has written more puts than he has purchased, he will need to buy back the written puts which have increased in value. Each JUL 45 put written is now worth $500. However, his long JUL 50 put is worth $1000 and is just enough to offset the losses from the written puts. Therefore, he achieves breakeven at $40.
Below $40, there will be no limit to the maximum possible loss. For example, at $30, each of the two written JUL 45 puts will be worth $1500 while his single long JUL 50 put is only worth $2000, resulting in a loss of $1000.
However, there is no upside risk to this trade. If the stock price had rallied to $50 or higher at expiration, all the options involved will expire worthless. Since the net debit to put on this trade is zero, there is no resulting loss.
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).
The following strategies are similar to the put ratio spread in that they are also low volatility strategies that have limited profit potential and unlimited risk.
The converse strategy to the put ratio spread is the ratio put backspread. Ratio put backspreads are used when large movements is expected of the underlying stock price.
The ratio spread can also be constructed using calls. The call ratio spread is similar to the put ratio spread strategy but has a slightly more bearish and less bullish risk profile.
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