The ratio spread is a neutral strategy in options trading that involves buying a number of options and selling more 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.
|Ratio Spread Construction|
|Buy 1 ITM Call|
Sell 2 OTM Calls
Using calls, a 2:1 call ratio spread can be implemented by buying a number of calls at a lower strike and selling twice the number of calls at a higher strike.
Maximum gain for the call 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 calls expire worthless while the long call expires in the money.
The formula for calculating maximum profit is given below:
Loss occurs when the stock price makes a strong move to the upside beyond the upper beakeven point. There is no limit to the maximum possible loss when implementing the call ratio spread strategy.
The formula for calculating loss is given below:
Any risk to the downside for the call 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.
There are 2 break-even points for the ratio spread position. The breakeven points can be calculated using the following formulae.
Using the graph shown earlier, since the maximum profit is $500, points of maximum profit is therefore equals to 5. Adding this to the higher strike of $45, we can calculate the breakeven point to be $50. (See example below)
Suppose XYZ stock is trading at $43 in June. An options trader executes a 2:1 ratio call spread strategy by buying a JUL 40 call for $400 and selling two JUL 45 calls 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 calls expire worthless while the long JUL 40 call expires in the money with $500 in intrinsic value. Selling or exercising this long call will give the options trader his maximum profit of $500.
If XYZ stock rallies and is trading at $50 on expiration in July, all the options will expire in the money but because the trader has written more calls than he has bought, he will need to buy back the written calls which have increased in value. Each JUL 45 call written is now worth $500. However, his long JUL 40 call is worth $1000 and is just enough to offset the losses from the written calls. Therefore, he achieves breakeven at $50.
Beyond $50 though, there will be no limit to the loss possible. For example, at $60, each written JUL 45 call will be worth $1500 while his single long JUL 40 call is only worth $2000, resulting in a loss of $1000.
However, there is no downside risk to this trade. If the stock price had dropped to $40 or below 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 ratio spread in that they are also low volatility strategies that have limited profit potential and unlimited risk.
The call ratio spread can also be used to repair a long stock position that has been hit with an unrealized loss. This stock repair strategy can reduce the price needed to breakeven on the long stock with virtually no cost.
The ratio spread can also be constructed using puts. The put ratio spread is similar to the call ratio spread strategy but has a slightly more bullish and less bearish risk profile.
The converse strategy to the ratio spread is the backspread. Backspreads are used when large movements is expected of the underlying stock price.
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