Ratio Spreads

Creating Ratio Spreads

In basic terms, options spreads are created when you simultaneously buy and write options contracts of the same type and on the same underlying stock. Typically, they involve buying the same amount of contracts as you write. For example, if you wrote 100 contracts then you would also buy 100 contracts.

However, ratio spreads involve buying a different amount of options than you write. The most common ratio used is a 2:1 ratio of contracts written to contracts bought. For example, if you wrote 100 options and then bought 50 of the same type, you would create a ratio spread with a 2:1 ratio. You can create these using either calls or puts.

Types of Ratio Spreads

There are a number of different types of ratio spreads, but they can all be classified as one of four many types, as follows.

Vertical Ratio Spreads: These are the most common and, as the name suggests, are a form of vertical spread. To create one you would sell options contracts, and then buy a smaller amount of contracts of the same type, on the same underlying stock and with the same expiration date, but with a different strike price.

Horizontal Ratio Spreads: This type involves selling options contracts and then buying a smaller amount of contracts of the same type on the same underlying stock with the same strike price, but with a later expiration date.

Diagonal Ratio Spreads: To create one of these you would sell options contracts and then buy a smaller amount of contracts of the same type and on the same underlying stock, but with a different strike price and with a later expiration date.

Ratio Backspreads: This refers to any ratio spread where you buy more options contracts than you sell.

Using Ratio Spreads

The main point of ratio spreads is for a trader to remove the need for an upfront payment when taking a long position on options contracts (i.e. buying them). By writing a higher amount of contracts and receiving a credit equal to or higher than the cost of the ones being bought. In theory, it's possible to profit from them regardless of whether the underlying stock goes up, goes down, or remains stagnant. This makes them a potentially powerful tool in options trading.

Let’s look at an example of one and how you can profit from it.

You use a buy to open order to buy 100 of the below options contracts at a cost of $200:

• Call
• Based on stock in Company X
• Company X stock currently trading at $50
• Strike Price of $49
• Ask Price of $2

You then use a sell to open order to write 300 of the below options contracts, creating a 3:1 ratio spread and receiving $210 for a net credit of $10.

• Call
• Based on stock in Company X
• Company X stock currently trading at $50
• Strike Price of $52
• Bid Price of $.70

If the stock price goes down to $48 by the expiration date, then the contracts you bought would expire worthless costing you your initial $200 investment in them. However, the contracts you wrote also expire worthless and as you received $210 for writing them you make a $10 profit from the spread.

If the stock price remained at $50 by the expiration date, then you could exercise your option from the contracts you bought for a gain of $1 per contract and a total of $100. As you paid $200 for the options, this represents a loss of $100 on this end of the spread. However, the ones you sold earned you $210 and expire worthless, so the spread earns you a total of $110 profit.

If the stock price went up to $52 by the expiration date, then you could exercise the contracts you bought for a gain of $3 per contract and a total of $300. Having paid just $200 for them, this represents a profit of $100 on this end of the spread. The options you sold earned you $210 and expire worthless, so the spread earns you a total of $310 profit.

Where you would lose in this example is if the stock price went up significantly. If the stock price rose to $56 by expiration, then you would be able to exercise for a $7 gain per contract and a total of $700. Subtract the $200 you spent on the options, this represents a $500 profit on this end of the spread. However, the options you wrote could be exercised for a cost to you of $4 per contract and a total of $1,200. Subtract the $210 you received for writing them, this represents a loss of $990 on this end, for a total loss of $290.

So although ratio spreads can be used to profit from the underlying security going up, going down, or remaining the same there is still an inherent risk if the price moves significantly in an unfavorable direction. If you are planning on using them as part of your options trading strategy then you should be aware of both the advantages and potential downsides.