Understanding Ratio Spreads

Advanced Options Strategies for Experienced Traders

Introduction

Ratio spreads are sophisticated options strategies that can be a powerful tool in the arsenal of experienced traders. By buying and selling an unequal number of options contracts, ratio spreads provide unique flexibility to tailor risk-reward profiles and potentially achieve higher profits.

While these strategies offer exciting possibilities, they also demand a deeper understanding of options pricing, risk management, and market dynamics. In this comprehensive guide, we’ll unravel the complexities of ratio spreads, providing the knowledge you need to navigate this advanced territory.

Delving Deeper into Ratio Spreads

Defining Ratio Spreads

At its core, a ratio spread involves buying a certain number of options (long) and selling a different number of options (short) with a different strike price, all on the same underlying asset and with the same expiration date. The ratio indicates the number of short options relative to the long options. For instance, a 2:1 ratio spread means you sell two options for every one option you buy.

Types of Ratio Spreads

• Call Ratio Spread (Backspread): In a call ratio spread, you buy call options at a lower strike price and sell a greater number of call options at a higher strike price. This is often used when you anticipate a substantial rise in the underlying asset’s price.
• Put Ratio Spread (Backspread): In a put ratio spread, you buy put options at a higher strike price and sell a greater number of put options at a lower strike price. This is employed when you expect a substantial fall in the underlying asset’s price.
• Front Ratio Spread: This involves buying one at-the-money or slightly out-of-the-money option and selling multiple further out-of-the-money options. It’s a net credit trade with limited downside risk but capped profit potential.

 The Anatomy of a Ratio Spread

Understanding the components of a ratio spread is crucial:

• Ratio: The number of short options divided by the number of long options (e.g., 2:1, 3:1).
• Strike Prices: The strike prices of the long and short options determine the potential profit and loss zones.
• Net Debit/Credit: Ratio spreads can be either debit spreads (where you pay a net premium) or credit spreads (where you receive a net premium).

Why Choose Ratio Spreads?

• Tailored Risk-Reward: By adjusting the ratio and strike prices, you can customize the risk and potential reward of the trade to match your outlook and risk tolerance.
• Higher Profit Potential: With the right market move, ratio spreads can offer higher profit potential than traditional debit spreads.
• Income Generation (Credit Spreads): Front ratio spreads, in particular, can generate income through the net credit received at initiation.

Real-World Examples of Ratio Spreads

Bullish Call Ratio Spread on Apple (AAPL): Deeper Analysis

Let’s revisit our earlier example with AAPL. If you buy two AAPL call options at $180 for $5 each and sell one AAPL call option at $200 for $2, your breakeven point is $188 (the lower strike price plus the net debit of $8).

• Scenario 1: AAPL rises to $220. Your profit would be $2,400 (($220 – $180) x 200 shares) – $800 (net debit) = $1,600.
• Scenario 2: AAPL stays at $190. Your profit would be $200 (the difference between the two call premiums).
• Scenario 3: AAPL drops to $170. Your loss would be limited to the net debit of $800.

Bearish Put Ratio Spread on Tesla (TSLA): Risk Management

In the TSLA example, where you buy one put option at $240 for $6 and sell two at $220 for $3 each, your maximum profit is $2,000 if TSLA is at or below $220 at expiration.

However, note the unlimited risk if TSLA rises significantly. For example, if TSLA reaches $280 at expiration, your loss would be $4,000 (($280 – $240) x 100 shares) + $600 (net credit) = $4,600. This is why risk management is crucial in ratio spreads.

Front Ratio Spread on Gold (GLD): Generating Income

Suppose gold (GLD) is trading at $180. You could create a 1:2 front ratio spread by:

1. Buying one GLD 180 call for $5
2. Selling two GLD 190 calls for $2 each

This would net you a $1 credit. Your maximum profit is this credit, achieved if GLD stays below $190. If GLD rises, your loss starts kicking in above $191, with a maximum loss if GLD is above $200 at expiration.