An Introduction To Ratio Spreads
Introduction
Early on, I liked options because of their incredible versatility. Just as warriors use different weapons for different combat situations, there’s an option strategy for every market situation. Besides just straight long and short options, traders can put together countless option strategies using different strike prices and expiration dates to create various risk-and-reward scenarios. One option strategy in particular, the ratio spread, seems almost too good to be true. With this strategy, it is possible at times to eliminate all or part of the downside or upside risk. So in this lesson, I will show you just what a ratio spread is and describe the ideal conditions to put on a ratio spread.
A ratio spread involves buying an at-the-money (ATM) or near-the-money option and selling multiple out-of-the-money (OTM) options with all of the options having the same expiration date. They can be constructed with either puts or calls. The ratio is usually two options sold for every one option bought. Though you can certainly have other ratios, just don’t go overboard and do a 1:8 ratio spread — you may not like the consequences. So what’s so good about a ratio spread? Well, how would you like a strategy in which you put up little or no money up front and would profit if you were right and not lose much or even gain a small profit if you were wrong?
Let’s look at a couple of examples.
Ratio Call Spread
Let’s say that we’re slightly bullish on ABC. With it currently trading at 70, we believe that it will stay in a range or move up slightly. Therefore, we can do a ratio call spread. A ratio call spread is constructed by buying an ATM call and selling two or more OTM calls. Consequently we would buy one ABC June 70 call at 6 and sell two June 80 calls at 4 each. In essence, we would be paying $600 for the June 70 call and receiving $800 for selling the two June 80 calls. Since we receive more for selling the OTM calls than for buying the ATM call, our spread would be done at a credit of 2 points or $200. If ratio call spreads are done at a credit, you can eliminate all of your downside risk. As we will later see, that $200 is ours to keep even if ABC goes to zero! Two important things that option traders should be aware of is their maximum profit potential and breakeven point. They should know how much money they stand to make and at what price would they breakeven. The formulas to calculate maximum profit and the breakeven point are:
Max Profit = (S2 – S1) +/- Credit/Debit
Max Profit = (80-70)+2 = 12 points or $1200
Breakeven Stock Price = S2 + {((S2 – S1) +/- Credit/Debit) * Extra Units Sold}
Breakeven Stock Price = 80 + {((80-70) + 2) * 1} = 92
S1 = Lower Strike Price
S2 = Higher Strike Price
Extra Units Sold = Number of options sold – Number of options bought
It’s also important to note that we will lose $100 for every point that ABC passes the breakeven price of 92. For instance, let’s say that ABC was at 93 at expiration. The June 70 call that we bought would be worth 23 while the June 80 calls sold are now worth 13 each. Therefore, we would make 23 points or $2300 on our June 70 call and lose 26 points or $2600 on the June 80 calls sold. This would be a loss of 3 points or $300, but recall that we received a credit of $200 for initiating the spread. So our net loss would be $100.
At expiration, there are three possible scenarios. First, ABC could be less than or equal to 70. Second, it could be greater than 70, but less than or equal to 80. Lastly it can be above 80.
Let’s say that we were wrong in our bullish forecast and ABC dropped to 60, the June 70 call that we bought would be worthless since we would not exercise our right to buy ABC at 70 while it’s trading at 60. The June 80 calls that we sold would also be worthless since no one in their right mind would exercise their right to buy stock from us at 80 while it’s trading at 60. So in this case both options expire worthless and we keep the 2 point credit or $200 that we received for doing the spread. Even if the stock went to zero, we would still profit from this transaction! If ABC did indeed dropped to zero, again both options would be worthless, but since we initiated the spread at a credit of 2 or $200, we can’t lose on the downside!
The best-case scenario for us would be if the stock ended up right at the strike price of the options sold. This is where our maximum profit is realized. If ABC ended up at 80, our June 70 call would be worth 10, while the June 80 calls sold would be worthless. So we would make 10 points or $1000 from the June 70 call and 2 points or $200 from initiating the spread, therefore our total profit would be 12 points or $1200.
Our worst-case scenario would be if the stock makes a rapid rise and ends up past the strike price of the option sold. This is where we begin to get into trouble. If ABC ended up at 100, our June 70 call would be worth 30 while the June 80 calls that we sold would now be worth 20 a piece. We would make 30 points or $3000 on the option bought and lose 40 points or $4000 on the options sold, which would be a loss of 10 points or $1000. However since we received a credit of 2 points or $200, our net loss is 8 points or $800. If the stock trades above the strike price of the options sold, you should close out your position.
Ratio Put Spread
If ABC would stay the same or decline a little, we could do a ratio put spread. A ratio put spread is constructed by buying an ATM put and selling two or more OTM puts. With ABC trading at 80, we would buy a June 80 put for 6 and sell two June 70 puts for 3.50 each. Therefore we would pay $600 for the June 80 put and receive $700 for selling the June 70 puts. Since we take in more money than we pay out, we will receive a credit of 1 point or $100 ($700 – $600). Because the spread was done at a credit we eliminated our upside risk. Even if ABC shot up to 100, both put options would be worthless and we would keep the $100. Again, we profit from this transaction even though we were wrong. The formula for calculating maximum profit and breakeven point are:
Maximum Profit = (S2 – S1) +/- Credit/Debit
Maximum Profit = (80 – 70) + 1 = 11 or $1100
Breakeven Stock Price = S1 – {((S2 – S1) +/- Credit/Debit) * Extra Units Sold
Breakeven Stock Price = 70 – {((80 – 70) + 1) * 1 = 59.
It’s important to note that for every point that ABC drops below 59, we will lose $100. For instance, let’s assume ABC was at 58 at expiration. The June 80 put that we bought would be worth 22 while the June 70 puts that we sold would now be in the money and worth 12 a piece. Therefore, we would make 22 points or $2200 on the June 80 puts and lose 24 points or $2400 on the two June 70 puts sold. We would lose 2 points or $200, but since we receive a $100 credit, our net loss is $100.
At expiration, there are also three possible scenarios. First, ABC could be greater than or equal to 80. Second, it could be less than 80, but greater than or equal to 70. Lastly, ABC could be under 70.
In the first scenario, we were wrong with our bearish forecast as ABC shoots up to 90. Our June 80 put would be worthless, since we would not exercise our right to sell stock at 80 while it’s trading at 90. The June 70 puts that we sold would also be worthless since the holder of those puts would not exercise their right to sell stock to us for 70. Recall that since we initiated the spread at a credit of $100 so that we eliminated our upside risk. We were wrong in our forecast and we still would make $100!
The best-case scenario would be if ABC ended right at the strike price of the options sold, this is where our point of maximum profit will be realized. If at expiration, XYZ were at 70, our June 80 put would be worth 10 or $1000. While the June 70 puts that we sold would be worthless. We would make 10 points or $1000 on the June 80 put and 1 point or $100 for doing the spread. Our total profit would be $1100. We put no money down and made $1100 in profit!
Our worst-case scenario would be if XYZ makes a fast and sharp drop and goes below 70. If XYZ suddenly drops to 50, the June 80 put would be worth 30 and the June 70 puts that we sold would be worth 20 a piece. Therefore we stand to make 30 points or $3000 on our June 80 puts, but we would lose 40 points or $4000 on the June 70 puts that we sold. In this case, we would lose 10 or $1000, but since we received a $100 credit, our net loss would be $900. When prices drop below the lower strike, you can really get into trouble. Watch the position closely and close the position if this happens.
Ideal Conditions for Ratio Spreads
As good as ratio spreads might sound right now, don’t go out and blindly do them. You need to understand the ideal conditions to do them.
The best time to do a ratio spread is when the stock is trading within a range or when it is slightly trending. So if you foresee a small rally or small decline, it may be time to look for a ratio spread opportunity.
Earlier on we saw how important it was to establish the spread at a credit, since it eliminated our downside risk is case of a ratio call spread or upside risk on a ratio put spread. Many times, it is not possible to obtain a credit when initiating a ratio spread. Only when there is a disparity in option premiums and implied volatilities of OTM options are high compared to ATM options there are good opportunities for ratio spreads.
Sell options that have a low probability of going in the money. Don’t sell strikes that have a good chance of becoming in the money. Focus on selling strike as far from the current price as possible.
Conclusion
The ratio spread is an excellent strategy from a risk-and-reward standpoint. It is a neutral to slight directional strategy with little or no upfront costs. You can profit when you’re right and even profit when you’re wrong. The only time you run into trouble is when you’re too right. Are good ratio spread opportunities here every day? No, but when the conditions are right, you should start to look for them.