Ratio spread

From MarketsWiki

A ratio spread is an option trading strategy that buys and sells both calls or both puts at two different strike prices in the same expiration month.

1 Creating the Ratio Spread
2 Strategy Outcomes
3 See Also
4 References

Creating the Ratio Spread

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Specifically, a ratio spread is created by buying an option and then selling a greater quantity of an option with a more out of the money strike price. For example, if a futures contract's current price is 100, a back spread could be created by buying a 90 put and then selling two 80 puts.

The option sales are ideally intended to finance the purchase of the closer option. This may involve selling a large number of farther out options if the premium difference between the near and far options is substantial.

The goal in establishing this position is to create a long option position in anticipation of a limited favorable move in the market. In the above example, a trader would likely be anticipating a downward move where the market proceeds slowly and steadily toward the 80 price, but either not quite getting to 80, or not going too far below 80 before expiration or offset.

Note that because more options are sold than purchased, this option strategy can contain extreme risk if the market moves sharply and/or for an extended period against the trader. As compared to back spread scenarios, a ratio spread has more ways to fail, and more ways to cause a lot of pain in that failure.

Strategy Outcomes

Note that none of the profit outcomes are unlimited for a ratio spread, while one of the loss scenarios is limited only by how far the market can go in the wrong direction before the position is offset.

If the market moves sharply in the direction of the purchased option and then becomes quiet, the purchased option may rise faster than the sold options, making it possible to offset the entire position for a net (though likely substantially limited) gain.

If the market in the long option's favor, into the money but not far enough to to make the short options in the money, then the options can expire for a net gain, or the position might be offset for a net gain prior to expiration.

If the market moves away from the long option and does not return, then whatever profit or loss that was realized in creating the position is the net result of the trade.

If the market moves sharply in the spread's direction and does not stop, then the long option will offset one of the short options for a gain of the difference between the long and short options' value. The remaining short options will increase in liability as the market continues to move. Offsetting the entire position could result in either profit or loss, depending on the market value of the uncovered short options, and the realized gain from the long option.^[1]