Ratio spread is a trading strategy that involves buying and selling options contracts with different strike prices and expiration dates to take advantage of market volatility.

This strategy can be used in bullish, bearish, or neutral market conditions, making it a versatile tool for traders.

In this article, we will provide a comprehensive guide to ratio spread strategy, including its definition, how it works, advantages, disadvantages, and examples.

What is a Ratio Spread Strategy?

Ratio spread is an options trading strategy that involves selling one or more options and buying a larger number of options of the same type with a different strike price and expiration date.

The ratio spread strategy is based on the idea that the trader expects the price of the underlying asset to move in a certain direction, but they also want to limit their risk in case the market moves against them.

The ratio spread strategy involves two types of options: call options and put options.

A call option is a financial contract that gives the holder the right, but not the obligation, to buy an underlying asset at a predetermined price (strike price) before a specific date (expiration date).

A put option, on the other hand, gives the holder the right, but not the obligation, to sell an underlying asset at a predetermined price before a specific date.

In a call ratio spread strategy, the trader buys a certain number of call options with a lower strike price and sells a greater number of call options with a higher strike price.

In a put ratio spread strategy, the trader buys a certain number of put options with a higher strike price and sells a greater number of put options with a lower strike price.

How Does This Strategy Work?

A ratio spread strategy works by taking advantage of the difference in premiums between the options contracts. When the trader buys and sells options with different strike prices, they will receive different premiums.

By selling more options than they buy, the trader can generate a credit that can be used to reduce the cost of the trade.

If the market moves in the direction they anticipated, they will profit from the difference in premiums.

If the market moves against them, they will have limited their risk because they bought more options than they sold.

For example, let’s say that the trader believes that the price of ABC stock will go up in the next month. They decide to use a call ratio spread strategy to take advantage of this.

They buy one ABC call option with a strike price of $50 that expires in one month, and sell two ABC call options with a strike price of $55 that expire in one month. The premium for the $50 call option is $3, and the premium for the $55 call options is $1.5 each. Therefore, the trader receives a credit of $0.5 ($3 – $1.5 x 2) for the trade.

If the price of ABC stock goes up to $60, the trader will make a profit of $4.5 ($10 – $5.5) because they bought one call option with a lower strike price and sold two call options with a higher strike price. However, if the price of ABC stock stays the same or goes down, the trader will still make a profit, but it will be limited to the credit they received for the trade.

Advantages of this Strategy

• Limited Risk: The ratio spread strategy allows traders to limit their risk because they buy more options than they sell. Even if the market moves against them, they will have limited their loss because they have purchased options that offset the options they sold.

• Versatility: The ratio spread strategy can be used in bullish, bearish, or neutral market conditions. Traders can use this strategy to profit from market volatility regardless of the direction of the market.

• Reduced Cost: The ratio spread strategy can reduce the cost of the trade because the trader sells more options than they buy. This generates a credit that can be used to offset the cost of the trade.

• Potential for Higher Profits: The ratio spread strategy can generate higher profits than a simple options trade because it involves buying and selling options with different strike prices. If the market moves in the direction the trader anticipated, they can profit from the difference in premiums.

• Hedging Opportunities: The ratio spread strategy can be used to hedge against losses in other trades. Traders can use this strategy to offset losses in other trades or to reduce their overall risk in the market.

Disadvantages of the Strategy

• Limited Profit Potential: The ratio spread strategy has limited profit potential because the trader sells more options than they buy. This limits their potential for profit if the market moves in the direction they anticipated.

• Complicated Strategy: The ratio spread strategy can be a complicated strategy for new traders to understand. It involves buying and selling options with different strike prices and expiration dates, which can be confusing for traders who are new to options trading.

• Market Volatility: The ratio spread strategy relies on market volatility to generate profits. If the market does not move in the direction the trader anticipated, they may not make a profit or may even lose money.

Examples of Ratio Spread Strategy

Call Ratio Spread

Let’s say that the trader believes that the price of XYZ stock will go up in the next month.

They decide to use a call ratio spread strategy to take advantage of this. They buy one XYZ call option with a strike price of $50 that expires in one month, and sell two XYZ call options with a strike price of $55 that expire in one month. The premium for the $50 call option is $3, and the premium for the $55 call options is $1.5 each. Therefore, the trader receives a credit of $0.5 ($3 – $1.5 x 2) for the trade.

If the price of XYZ stock goes up to $60, the trader will make a profit of $4.5 ($10 – $5.5) because they bought one call option with a lower strike price and sold two call options with a higher strike price. However, if the price of XYZ stock stays the same or goes down, the trader will still make a profit, but it will be limited to the credit they received for the trade.

Put Ratio Spread

Let’s say that the trader believes that the price of PQR stock will go down in the next month.

They decide to use a put ratio spread strategy to take advantage of this. They buy two PQR put options with a strike price of $50 that expire in one month, and sell one PQR put option with a strike price of $45 that expires in one month. The premium for the $50 put options is $3 each, and the premium for the $45 put option is $1.5. Therefore, the trader receives a credit of $0.5 ($1.5 x 1 – $3 x 2) for the trade.

If the price of PQR stock goes down to $40, the trader will make a profit of $4.5 ($10 – $5.5) because they bought two put options with a higher strike price and sold one put option with a lower strike price. However, if the price of PQR stock stays the same or goes up, the trader will still make a profit, but it will be limited to the credit they received for the trade.

Ratio spread strategy variants

In addition to the call and put ratio spread examples mentioned earlier, there are other variations of this strategy that traders can use to suit their specific needs and market outlooks.

For instance, traders can use the debit call ratio spread to trade bullish markets by buying one call option with a lower strike price and selling two call options with a higher strike price. This strategy can be used to take advantage of market momentum while limiting the trader’s risk exposure.

Similarly, traders can use the debit put ratio spread to trade bearish markets by buying two put options with a higher strike price and selling one put option with a lower strike price. This strategy can help traders profit from a decline in stock prices while limiting their risk exposure.

Another variation is the calendar ratio spread. This strategy involves buying and selling options with different expiration dates rather than different strike prices. Traders can use this strategy to generate income while minimizing risk, as they can profit from the time decay of the options they sell.

Conclusion

The ratio spread strategy is a versatile options trading strategy that can be used in bullish, bearish, or neutral market conditions. It involves buying and selling options with different strike prices and expiration dates to generate a credit that can be used to offset the cost of the trade. This strategy can be used to reduce risk, generate income, and hedge against losses in other trades.

However, this strategy also has its drawbacks. It has limited profit potential, can be a complicated strategy for new traders to understand, and relies on market volatility to generate profits.

When implementing this strategy, it’s important for traders to carefully consider their market outlook and risk tolerance. They should also pay close attention to market conditions, including volatility levels and option pricing, to ensure that they are entering the trade at the most opportune time.