Ratio Spread: Definition, Examples, And Profit-Loss Calculation
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Summary:
A ratio spread is a neutral options strategy that involves holding unequal numbers of long and short options. In this article, we’ll explore what a ratio spread is, provide examples, and explain how to calculate profits and losses.
What is a ratio spread?
A ratio spread is a nuanced options trading strategy that falls under the category of neutral strategies. This approach involves an investor holding an unequal number of long and short (written) options. The name “ratio” is derived from the specific proportion between short and long positions. In the most common scenario, the ratio is two to one, indicating that there are twice as many short positions as long ones.
Unlike some other strategies where long and short positions are balanced, a ratio spread allows for a bit more complexity. It offers a practical approach for traders who anticipate minimal price movement in the underlying asset but still want to maintain a certain level of flexibility in their strategy. The primary concept behind a ratio spread is to capitalize on a relatively stable market where price changes are expected to be limited.
Understanding the ratio spread
Traders resort to a ratio spread when they anticipate that the underlying asset’s price won’t experience significant fluctuations, although they may have a slight bullish or bearish bias depending on the chosen ratio spread trade.
For traders with a slightly bearish outlook, the put ratio spread is the preferred choice. In this scenario, the trader buys an at-the-money (ATM) or out-of-the-money (OTM) put option and concurrently writes two put options with lower strikes that are further OTM.
On the other hand, those with a slightly bullish view opt for the call ratio spread. This involves buying an ATM or OTM call option and simultaneously writing two call options with higher strikes, which are further OTM. The chosen ratio is a crucial factor in the strategy. The conventional ratio is two written options for each long option, but traders have the flexibility to adjust this ratio based on their market expectations and risk tolerance.
Example of a ratio spread trade in Apple Inc.
Now, let’s delve into a real-world scenario to illustrate how a ratio spread trade works. Imagine a trader’s interest in placing a ratio spread on Apple Inc. (AAPL) because they anticipate that the stock price will either remain flat or experience only marginal growth over the next two months. Here’s how the trade unfolds:
The trader decides to buy one call option with a strike price of $210, which costs $6.25 per option, resulting in a total cost of $625.
Simultaneously, the trader sells two call options with a strike price of $215, each priced at $4.35, for a total income of $870.
As a result, the trader receives a net credit of $245. This credit represents their potential profit if the stock either remains below $210 or experiences a decline because, in both cases, the options expire worthless.
If the stock’s price falls within the $210 to $215 range at the time of expiration, the trader profits not only from the option positions but also from the initial credit. For example, if the stock is trading at $213, the bought call option is worth $3 each, resulting in a profit of $300. When combined with the $245 credit from the sold calls, this totals a profit of $545. The maximum profit is achieved when the stock price aligns with the $215 strike price.
However, if the stock’s price surpasses $215 at expiration, the trader faces potential losses. For instance, if the stock price reaches $225, the trader incurs a loss.
Advanced variations of ratio spreads
While the basic concept of a ratio spread involves buying one option and selling multiple options with differing strikes, there are more advanced variations that traders can consider:
Variable ratio spread:
This strategy allows traders to adjust the ratio between long and short options as the market conditions change. For example, if the market becomes more volatile, a trader can increase the number of short options to hedge against potential losses.
Time-based ratio spread:
Time decay, or theta, is a crucial factor in options trading. Traders can apply a time-based ratio spread by selecting options with different expiration dates. This approach leverages the concept that shorter-dated options decay faster than longer-dated ones. For instance, a trader can buy a longer-dated call option while selling multiple shorter-dated call options.
Diagonal ratio spread:
A diagonal ratio spread combines elements of a diagonal spread with the ratio spread. In this strategy, a trader buys a long option with a distant expiration date and sells multiple options with nearer expiration dates. This approach is suitable when the trader anticipates modest price movements in the short term, but greater fluctuations in the long term.
Real-world case study: Ratio spread in action
Let’s examine a real-world scenario to better understand how a ratio spread can be applied:
Company X stock (Ticker: XYZ) is currently trading at $100 per share. A trader believes that the stock’s price will remain relatively stable over the next three months. To create a ratio spread, the trader takes the following steps:
- Buy one call option with a $100 strike price, expiring in three months, at a cost of $5 per option ($500 total).
- Sell two call options with a $105 strike price, expiring in three months, for $3 each ($600 total credit).
This results in a net credit of $100. Here’s how the trade performs under different scenarios:
Scenario 1: Stock remains stable (e.g., stays at $100)
All options expire worthless. The trader retains the $100 credit as profit.
Scenario 2: Stock rises modestly (e.g., to $103)
The bought call option is in the money and has a value of $3 each ($300 total). When combined with the $100 credit, the trader’s profit is $400.
Scenario 3: Stock surpasses $105 (e.g., reaches $110)
The bought call option is in the money, with a value of $5 each ($500 total). The two sold call options have a combined cost of $6 each ($1,200 total cost). In this scenario, the trader faces a loss of $700.
By examining this case study, we can see how a ratio spread provides traders with a strategy to profit from stable or slightly bullish market conditions while managing risk.
Monitoring and adjusting a ratio spread
It’s essential for traders to actively monitor their ratio spread positions. Market conditions can change, and adjustments may be necessary to optimize the strategy. For instance, if the stock’s price approaches the short option strike, the trader might consider closing or rolling the position to avoid potential losses.
Moreover, implementing stop-loss orders or profit-taking levels can help traders maintain discipline and protect their capital when using ratio spreads.
The bottom line
In summary, a ratio spread is a versatile strategy in the world of options trading. It is well-suited for traders who anticipate limited price movement in an underlying asset, and it allows for slight bullish or bearish views depending on whether it’s a call ratio spread or a put ratio spread. The strategy offers the potential for profit when the price remains within the short option strike prices. However, it’s crucial for traders to be aware of the potential for unlimited losses if the price makes a significant move against their chosen strategy. Adjusting the ratio allows traders to fine-tune their approach, and the maximum profit occurs when the underlying asset’s price aligns with the short option strike.
Frequently asked questions
What is the primary purpose of a ratio spread?
A ratio spread aims to profit from minimal price movement in an underlying asset, with variations like call ratio spreads for bullish outlooks and put ratio spreads for bearish outlooks.
Why is there theoretically unlimited loss potential in ratio spreads?
Ratio spreads involve more written (short) positions than long positions, leading to potential unlimited losses if the asset’s price significantly deviates from the strike prices of written options.
Can the ratio in a ratio spread be adjusted?
Yes, traders can alter the ratio of written options to long options based on their risk tolerance and market expectations.
When is the maximum profit achieved in a ratio spread?
The maximum profit in a ratio spread occurs when the underlying asset’s price settles at the strike price of the short options.
What should traders be cautious about in ratio spreads?
Traders should be aware of the risk of substantial losses if the price makes a significant move in the opposite direction of their strategy.
Key takeaways
- A ratio spread is a neutral options strategy involving unequal numbers of long and short options.
- It capitalizes on minimal price movement in the underlying asset, making it suitable for stable market conditions.
- There are two primary types: call ratio spreads for bullish views and put ratio spreads for bearish views.
- Adjusting the ratio allows traders to customize the strategy based on their market expectations.
- Traders should monitor their ratio spread positions as market conditions change to optimize their strategy.
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