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Published On: Sat, Dec 8th, 2012

Ratio Options Spreads

A ratio spread is simply an options spread where more options are sold than bought or vice versa.

When a ratio spread is set up for a net credit, this gives the trade the rather unique ability
to profit from 3 different market conditions: when the price of the underlying asset remains
stagnant, when it moves somewhat in the favoured direction and also when it moves totally in
the opposite direction.

One of the simplest examples of a ratio credit spread is the well-known call ratio spread. Fig.
8.20(a) below is a risk/profit chart for this spread.

 

 

 

 

 

Fig. 8.20(a)

From this chart we can clearly see that:

The spread has limited profit potential to the downside;
It has a relatively large, but limited profit potential to the upside;
It has unlimited loss potential further to the upside and
If the price of the underlying asset remains stagnant, the spread also shows a profit

a) The spread has limited profit potential to the downside;
b) It has a relatively large, but limited profit potential to the upside;
c) It has unlimited loss potential further to the upside and
d) If the price of the underlying asset remains stagnant, the spread also shows a profit

How to enter a call ratio spread

A call ratio spread is entered into by

a) Buying a certain number of ATM or slightly OTM options and
b) Simultaneously selling a larger number of further OTM options on the same
underlying asset and for the same expiration date.

The cost of the options that are purchased are more than offset by the income derived from
the options that are sold, making this a credit spread. Common ratios are 2:1 (two options
sold for every one purchased and 3:1 – although the maximum is only limited by the trader’s
risk appetite.

Profit/loss scenario for the call ratio spread

The spread achieves its maximum profit at the strike price of the short options. The profit at
this level can be significant and depends on how many long options were purchased relative
to the options that were sold. If the price moves beyond that, the profit starts shrinking rapidly
and eventually moves into a loss which can become substantial if the trader does not exit the
position at a predetermined level.

Coming back to Fig. 8.20(a): If the price of the underlying asset moves down the net profit will
be the difference between the selling price of the short options and the purchase price of the
long options.

Other types of ratio spreads

There are many other types of ratio spreads. Two of them are diagonal and horizontal ratio
spreads, which form part of advanced calendar spreads. We will discuss these in more depth
in a later article.

Ratio backspreads are the mirror images of the credit ratio spreads discussed in this article.
They are put on by purchasing more ATM or slightly OTM options than the number of further
ITM options that are sold.

Fig. 8.20(b) below is an example of a call ratio backspread.

 

 

 

 

 

 

Fig. 8.20(b)

This type of trade can e.g. be entered into by purchasing two ATM or slightly OTM call options
and simultaneously selling one ITM call option. This gives the spread the unique ability (for a
credit spread) to be able to realise unlimited profit to the upside while still making a profit if the
price should break out to the downside.

 

 

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.

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