Put Ratio Spread
The put ratio spread is a complicated options trading strategy, but it has some significant benefits. Although it's considered a neutral strategy, it won't only return a profit when the price of a security doesn't move, but also when it goes up: no matter how much it goes up by.
This strategy actually returns the maximum profit when the price of the security drops a little, meaning there are three separate ways it can make you money. It does lose money if the price of the security should drop significantly though. We have provided more details on this strategy below.
The Key Points
- Neutral Strategy
- Not Suitable for Beginners
- Two Transactions (buy puts and write puts)
- Credit Spread (upfront credit received)
- Medium/High Trading Level Required
When to Apply the Put Ratio Spread
The put ratio spread is a versatile strategy, and it effectively has multiple purposes. It actually returns the maximum profit when the underlying security falls by a little to a specific price. However, it also profits when the underlying security remains at the same price, which is essentially why it's regarded as a neutral trading strategy. Additionally, it will return a profit if the underlying security increases in price, whether by a little or by a lot.
It's a good strategy to use if your expectation is that the price of a security will drop by a small amount, but you think there's a chance it won’t move at all and might even go up. The spread will return a substantial loss if the security falls significantly in price, so it's not good to use it if you think that could possibly happen.
How the Put Ratio Spread is Applied
There are two legs in this spread. Unlike many options trading strategies, these legs aren't created using an equal amount of options in each. This fact, combined with the fact that only puts are used, is what gives the put ratio spread its name. You have two major decisions to make when creating the spread: what ratio to use and what strikes to use. These decisions aren't particularly easy, and this isn't a strategy that should really be considered by inexperienced traders.
When applying the spread you must buy puts and also write a higher number of puts (based on the same security) with a lower strike. As we have said, you must decide what ratio to use; we would suggest that you start by using 2 to 1 or 3 to 1. This means you should write either two times as many puts you buy, or three times as many. You can also use a ratio between these two (for example 2.5 to 1).
In terms of strikes, we would recommend buying at the money contracts and writing contracts with a lower strike that is roughly equal to the price you think the security will fall to.
Once you have a bit of experience with this strategy, you can start experimenting with different ratios and strikes that may better help you achieve your objectives. You should always bear in mind that you want to create this as a credit spread, so the total credit received for writing contracts should be greater than the total debit for buying contracts.
Below we have provided an illustration of how the put ratio spread can work. This example doesn't use real market data, but it should give you a rough idea of how the numbers work.
- Company X stock is trading at $50, and your expectation is that the price won’t move much but might fall a little to around $48.
- Puts with a strike of $50 are trading at $2. You buy 1 contract (a contract contains 100 options) at a cost of $200. This is Leg A.
- Puts with a strike price of $48 are trading at $1. You buy 3 contracts (a total of 300 options) for a credit of $300. This is Leg B.
- You have now created a put ratio spread. The ratio is a 3 to 1 and the net credit is $100.
Potential Profits & Losses
The maximum profit is achieved when the price of the underlying security is equal to the strike of the options written by the point of expiration. In this example, this would be if the price of Company X stock is $48. Such a scenario would mean that the options bought (in Leg A) would expire in the money, and the ones written (in Leg B) would expire at the money, and therefore they would be worthless.
Should the Company X stock go below $48, then the options written in Leg B would be in the money and carry a liability. At this point, the position would start to reverse and move towards a loss. As you have written three times as many options as you bought, your liabilities would increase at a faster rate than the value of the ones owned.
You'll also make a profit if the underlying security stays at $50, or if it goes up. Should either of these things happen, both sets of contracts (those written in Leg A and bought in Leg B) will expire worthless: meaning that the net credit received initially is your total profit. We have provided some hypothetical scenarios below to show exactly what would happen in some different scenarios.
- If the price of Company X stock stays at $50 or goes up, then all the contracts will expire worthless. With returns to come and no liabilities, your profit will be the $100 net credit received.
- If the price of Company X stock is between $48 & $50 at the time of expiration, then the puts you wrote in Leg B will be expire worthless, meaning you will have no liabilities. The ones you bought in Leg A, however, will be in the money and have some value. Your profit will be the value of the puts owned plus the net credit received.
- If the price of Company X stock is at $44 at expiration, then the puts in Leg A will be worth around $6 each and a total value of $600. The ones you wrote in Leg B will be worth around $4 each and you will have a total liability of $1,200. Your loss will be your liability ($1,200) minus the value of the puts owned ($600) and the initial net credit ($100): for a total of $500. This loss would be higher if the price of the underlying security was even lower.
We have included some calculations below that you can use to determine the potential profitability of the put ratio spread and the potential losses.
- Maximum profit is made “Price of Underlying Security = Strike of Options in Leg B”
- Maximum profit is “((Strike of Options in Leg A – Strike of Options in Leg B) x Number of Options Bought in Leg A) + Net Credit Received”
- Profit is also made when “Price of Underlying Security = or > Strike of Options in Leg A)”
- Profit in the above scenario is the Net Credit Received.
- Profit is also made when “Price of Underlying Security < Strike of Options in Leg A and > Strike of Options in Leg B”
- Profit in the above scenario is “((Strike of Options in Leg A – Price of Underlying Security) x Number of Options Bought in Leg A) + Net Credit Received”
- A loss is made if the price of the underlying security falls so far that “Value of Options in Leg B > (Value of Options in Leg A + Net Credit)”
- Losses will be “(Value of Options in Leg B – Value of Options in Leg A) – Net Credit”
The put ratio spread does have the distinct advantage of being able to profit from multiple scenarios. If the price of the security should stay the same or go up, it will profit. It will also profit if the price of the security does down, providing it doesn't go down too far and the value of the options written exceeds the value of the ones owned.
If that should happen, the potential losses can be substantial, which means there's a significant risk involved. This is not a simple strategy, and you really need a decent level of experience to work out the best ratio and strikes to use.