The Bear Ratio Spread

Why Use This Spread?

This is one of a number of strategies that are very flexible in the way they can be used. The main use of the bear ratio spread is to try and profit when you are the expecting a security to fall in price and believe you know roughly how much the price will fall by. Because of its flexibility, in terms of the strikes you use and the ratio at which you write options, you can use the spread in a way that suits you.

You can use it to lessen the upfront costs required to speculate on a downward price movement for example. You can also use it so that you can profit if the security stays at the same price or increases a little, as well as profiting from it going down in price. Once you fully understand how it works, you can use the strategy according to exactly what your outlook and objectives are.

Establishing the Bear Ratio Spread

There are two transactions required: buying puts and also writing a larger number of puts. The flexibility of the strategy is in the fact that you can determine the strikes you use for these transactions and also the amount of options you write relative to the amount you buy. By adjusting the strikes and the ratio to suit, you can try and get the most out of a particular forecast or prediction.

There are no specific rules as to what ratio you should use, or what strikes you should use, but we would advise that you keep things as simple as possible until you have used the spread a few times.

A good guideline is to buy put options contracts that are at the money, and then write contracts with a lower strike that is roughly equivalent to the price you expect the relevant underlying security to fall to. The strike you use when writing the contracts will ultimately determine how much profit you can make out of this strategy, and will also affect how much cost you incur upfront.

With a lower strike you can make more profits, but contracts with a lower strike are cheaper so you'll receive less money for writing them. The amount of contracts you write will also affect the cost of the spread. The more you write, the more money you will receive and therefore the lower the net cost will be. You can even write enough contract, if you want, so that you receive a net credit at the outset.

Potential for Profit & Loss

In very basic terms, this spread makes a profit if the price of the underlying security falls. However, because of the way it's constructed (writing more puts than you buy) if the price of the underlying security falls by too much (below the strike of the contracts written), then you can potentially lose money.

There's a maximum potential profit, which is made when the price of the underlying security falls to exactly the strike of the puts written. In this scenario, the puts bought will generate a profit for you, but the ones written will expire worthless.

Assuming you have spent more money on buying puts than you have received for writing puts options (i.e. you have created a debit spread), then you will lose money if the price of the underlying security either stays stable or increases. This is due to the fact that all the contracts, bought and written, will expire worthless and your loss will be the amount of the net debit.

If you have received more for writing puts than you have spent on buying puts (i.e. you have created a credit spread), then the you will make money if the price of the underlying security stays stable or increases. As all the contracts will still expire worthless, you will keep any net credit received as your profit.

Advantages & Disadvantages

The flexibility that this strategy offers is probably its greatest advantage, because the fact that you can use it in a way that best suits your objectives is a real benefit. Whether you are looking to increase your potential profits, reduce your upfront costs, or profit even if the underlying security doesn't go down in price, you can adjust things to help you achieve your goals.

This flexibility, though, is in some ways also it biggest disadvantage, because it's a complicated strategy to get to grips with. It can be difficult to know exactly how best to use it, which is why it should only really be used by reasonably experienced traders.

Example

Here we have provided an example of how the bear ratio spread can be established, along with what the outcome would be in some hypothetical scenarios. Please be aware that this example is intended purely to provide a rough guide to how the strategy works; it doesn't use exact options prices and we haven't included commission charges.

Initial Trade

• Company X stock is trading at $50, and you expect it to decrease in price to around $46.
• At the money puts on Company X stock (strike price $50) are trading at $2 and out of the money puts on Company X stock (strike price $46) are trading at $.20.
• You buy 1 put options contract with a strike price of $50 (each contract contains 100 options) at a cost of $200. This is Leg A.
• You write 2 put options contracts with a strike price of $46 (each contract contains 100 shares) for a credit of $40. This Leg B.
• You have created a bear ratio spread for a net debit of $160.

If Company X stock does not go down in price, or increases, by expiration

The puts that you have written in Leg B will expire worthless so you have no further liabilities. However, the ones bought in Leg A also expire worthless so you will receive no returns. You will have lost the $160 net debit at the time of applying the strategy.

If Company X stock goes down to $46 by expiration

The puts that you have written in Leg B will be at the money, and they will expire worthless. The ones owned, though, will be in the money and worth around $4 each: $400 in total. After deducting your initial investment of $160, your profit is $240.

If Company X stock goes down to $42 by expiration

The puts that you wrote in Leg B will expire in the money. Each option will be worth around $4, for a total liability of $800. The puts that you bought in Leg A will be worth around $8, for a total of $800. The values of the long leg (Leg A) and the short leg (Leg B) will approximately cancel each other out, leaving you with your initial investment of $160 as your loss.

If Company X stock fell even further in price, then your losses would increase. The puts owned would increase in value, but the ones written would increase in value at the same rate and you have written double the amount of those. You could, of course, close the position at any time by selling to close Leg A and buying to close Leg B.

Profit, Loss & Break-Even Calculations

• Maximum profit is limited.
• Maximum profit is made when “Price of Underlying Security = Strike Price of Leg B”
• Maximum profit, per option owned, is “(Strike Price of Leg A – Strike Price of Leg B) – (Price of Option in Leg A – (Price of Option in Leg B x Ratio Used))”
• Ratio Used = “Number of Options in Leg B / Number of Options in Leg A”
• Loss is limited to the net debit if “Price of Underlying Security >= Strike Price of Leg A"
• Note, if a credit spread has been created instead of a debit spread, the spread will be in profit if “Price of Underlying Security >= Strike Price of Leg A"
• Loss is potentially unlimited if “Price of Underlying Security < Strike Price of Leg B”
• The amount of potential losses will depend on whether a credit spread or debit spread has been created and what ratio has been used. We would advise you to carry out your own calculations when using this strategy in order to work out what the potential losses might be.
• Break-even points will also depend on whether a credit or debit spread has been created, and what ratio has been used.

Summary

This is definitely one of the most effective options trading strategies, providing you fully understand how to construct it to give yourself the best chance of achieving your objectives. It is, however, a complex strategy and you need to work out the best strikes to use and also the right ratio of options written to options bought.

For this reason alone it this isn't an ideal strategy for beginners. More experienced traders should be able to make good returns from the bear ratio spread.