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Are you interested in exploring options to diversify your investments? Options offer traders a chance to make a profit, but let’s face it, they can be complicated. For newcomers, complex strategies and terms can be daunting. However, experienced traders have a trick up their sleeve – enter the ratio spread!
In this article, we’ll learn more about ratio spreads, how they work, and when to use them.
Overview of ratio spread?
A ratio spread is a non-directional options strategy wherein the trader holds unequal long and short contracts. The ‘ratio’ refers to the specific preset ratio between the number of long and short contracts.
The most common ratio spread is the 2:1 ratio. Here, if the trader buys 3 contracts, they would sell 6 contracts, maintaining the 2:1 ratio. The trader believes the underlying asset will have a moderate price movement but is unsure of the direction. Using the ratio spread helps bring down the net premium cost.
Understanding call ratio spreads
Ratio spreads can be of two types – call ratio spreads and put ratio spreads. Before we dive into the technical details, let’s take a moment to understand what call ratio spreads are.
In the trading world, there is a call ratio spread strategy. This trader buys call options (which give them the right to buy an underlying asset) at a lower price and sells more call options at a higher price. For example, they could buy one option that lets them buy something at a price of ₹100 and sell two options that let them buy it at a higher price of ₹130.
The ratio spread strategy is a method used to make money when the price of an asset doesn’t increase too much. The strategy can make you money if the price increases and stays below a certain point. However, you might lose money if the price goes above this point. The best outcome is when the price is at a specific point, giving you the most profit.
Constructing a call ratio spread
A sample 2:1 call ratio spread can be constructed as:
- Buy 1 in-the-money call option
- Sell 2 out-of-the-money call options
The in-the-money and out-of-the-money short calls are two types of investment contracts with the same expiration date and underlying asset. The difference is the price at which each contract can be exercised.
In simpler terms, the in-the-money call contract has a lower exercise price than the out-of-the-money short call contract. The contracts can be bought and sold in a predetermined ratio, which affects the potential profit and loss of the investment.
Call ratio spread example
Let’s understand this with an example of a 2:1 call ratio spread on ABC Ltd trading at ₹150:
- Buy 1 ABC Ltd. call option with a strike price of ₹140 at ₹12 premium
- Sell 2 ABC Ltd. call options with a strike price of ₹160 at ₹8 premium
The net credit received is ₹4 [2*8 – 12]. This is the maximum profit if ABC Ltd. trades below ₹140 or drops at expiration.
If ABC rises to ₹160 at expiration, the long 140 strike call option gets exercised, while the two short 160 strike calls expire worthless. This yields the maximum profit. Above ₹160, losses accumulate on the short calls.
Benefits of ratio call spreads
- Requires lower net premium outlay
- Profits if the stock moves up moderately
- Leverages limited upside forecasts
The call ratio spread works well when one expects a limited upside in the underlying asset. By selling more calls than buying, the strategy aims to pay for the long option’s premium cost partially or fully.
Understanding put ratio spreads
When a trader anticipates a moderate decrease in the price of an asset, they may employ a ratio spread strategy. This involves buying options that are already in-the-money (meaning the asset price is higher than the option strike price) and then selling more options that are out-of-the-money (meaning the asset price is lower than the option strike price) at a lower price. The idea is to profit if the asset price stays unchanged, but not too much.
For instance, a put ratio spread can be structured as:
- Buy 1 put option at ₹180 strike
- Sell 2 put options at ₹150 strike
The maximum profit is attained if the stock drops to ₹150 or below at expiration. On the upside, losses accumulate if the stock trades above the long put strike price of ₹180.
Ratio spreads adjustments
After placing a ratio spread trade, the trader needs to keep an eye on the trade and the market trend. If the market moves in a way that could cause the trader to lose money, or if there’s a chance to lock in profits earlier, the trader may need to adjust the trade. By doing this, they can minimise losses and maximise gains.
Common adjustments include:
- Closing out leg(s)
- Rolling to a different expiration date
- Widening or narrowing strikes
- Changing contract ratios
Ratio spreads involve advanced options strategies. So, understanding the Greeks, volatility, time decay, and logical adjustments are critical to effectively trading ratio spreads.
Conclusion
Ratio spreads are a trading strategy that uses call-and-put options to benefit from moderate price movements in either direction. The idea is to sell more options than you buy in a specific ratio, which can help to reduce the overall cost. However, managing your trades by keeping an eye on your options and adjusting them is essential to make a profit or avoid losing money. While ratio spreads may sound attractive, they require a good understanding of options trading and logical thinking to be successful.
FAQs
A ratio spread involves taking an unequal number of long and short positions in calls or puts on the same asset, unlike other spread strategies with an equal ratio. The imbalance allows profits from a moderate move while reducing net premium costs.
Call ratio spreads work by buying fewer in-the-money calls and selling more out-of-money calls in a preset ratio. Profits occur if the asset price rises moderately and expires between the strikes at maturity. The imbalance cushions the downside if wrong.
Input ratio spreads: traders buy fewer in-the-money puts and sell more out-of-the-money puts at a fixed ratio. Profits accrue if the asset price sees a mild decline and expires between the strikes. Higher short puts reduce premium costs.
One can tweak strikes, ratios, and option types in ratio spreads to alter the boundaries of maximum profits and losses. A higher ratio like 3:2 skews risk-reward by increasing the profit cushion but lowering the upside.
Given the advanced structure requiring unequal positions, ratio spreads may pose risks for novice traders. Extensive backtesting and paper trading are advised before allocating natural capital to ratio spreads.
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