Ratio Spread Explained

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Ratio Spread

The ratio spread is a neutral strategy in options trading that involves buying a number of options and selling more options of the same underlying stock and expiration date at a different strike price. It is a limited profit, unlimited risk options trading strategy that is taken when the options trader thinks that the underlying stock will experience little volatility in the near term.

Ratio Spread Construction
Buy 1 ITM Call
Sell 2 OTM Calls

Call Ratio Spread

Using calls, a 2:1 call ratio spread can be implemented by buying a number of calls at a lower strike and selling twice the number of calls at a higher strike.

Limited Profit Potential

Maximum gain for the call ratio spread is limited and is made when the underlying stock price at expiration is at the strike price of the options sold. At this price, both the written calls expire worthless while the long call expires in the money.

The formula for calculating maximum profit is given below:

  • Max Profit = Strike Price of Short Call – Strike Price of Long Call + Net Premium Received – Commissions Paid
  • Max Profit Achieved When Price of Underlying = Strike Price of Short Calls

Unlimited Upside Risk

Loss occurs when the stock price makes a strong move to the upside beyond the upper beakeven point. There is no limit to the maximum possible loss when implementing the call ratio spread strategy.

The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Price of Underlying > Strike Price of Short Calls + ((Strike Price of Short Call – Strike Price of Long Call + Net Premium Received) / Number of Uncovered Calls)
  • Loss = Price of Underlying – Strike Price of Short Calls – Max Profit + Commissions Paid

Little or No Downside Risk

Any risk to the downside for the call ratio spread is limited to the debit taken to put on the spread (if any). There may even be a profit if a credit is received when putting on the spread.

Breakeven Point(s)

There are 2 break-even points for the ratio spread position. The breakeven points can be calculated using the following formulae.

  • Upper Breakeven Point = Strike Price of Short Calls + (Points of Maximum Profit / Number of Uncovered Calls)
  • Lower Breakeven Point = Strike Price of Long Call +/- Net Premium Paid or Received

Using the graph shown earlier, since the maximum profit is $500, points of maximum profit is therefore equals to 5. Adding this to the higher strike of $45, we can calculate the breakeven point to be $50. (See example below)

Example

Suppose XYZ stock is trading at $43 in June. An options trader executes a 2:1 ratio call spread strategy by buying a JUL 40 call for $400 and selling two JUL 45 calls for $200 each. The net debit/credit taken to enter the trade is zero.

On expiration in July, if XYZ stock is trading at $45, both the JUL 45 calls expire worthless while the long JUL 40 call expires in the money with $500 in intrinsic value. Selling or exercising this long call will give the options trader his maximum profit of $500.

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If XYZ stock rallies and is trading at $50 on expiration in July, all the options will expire in the money but because the trader has written more calls than he has bought, he will need to buy back the written calls which have increased in value. Each JUL 45 call written is now worth $500. However, his long JUL 40 call is worth $1000 and is just enough to offset the losses from the written calls. Therefore, he achieves breakeven at $50.

Beyond $50 though, there will be no limit to the loss possible. For example, at $60, each written JUL 45 call will be worth $1500 while his single long JUL 40 call is only worth $2000, resulting in a loss of $1000.

However, there is no downside risk to this trade. If the stock price had dropped to $40 or below at expiration, all the options involved will expire worthless. Since the net debit to put on this trade is zero, there is no resulting loss.

Note: While we have covered the use of this strategy with reference to stock options, the ratio spread is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the ratio spread in that they are also low volatility strategies that have limited profit potential and unlimited risk.

Call Ratio Spread

The call ratio spread is a complex options trading strategy that isn’t recommended for beginner or inexperienced traders. It’s generally considered a neutral strategy, because it’s typically used when the expectation is that the price of a security won’t move by very much.

It can actually potentially return a profit in three different scenarios; if the price of the security goes up a little, goes down, or stays the same. This gives the spread a very good chance of returning a profit, and it can only lose money if the price of the security goes up substantially. Please see below for further details.

Key Points

  • Neutral Strategy
  • Not Suitable for Beginners
  • Two Transactions (buy calls and write calls)
  • Credit Spread (upfront credit received)
  • Medium/High Trading Level Required

When the Call Ratio Spread is Used

Although it’s considered a neutral strategy, the call ratio spread is actually best used when you believe that a security will go up in price by a relatively small amount, because this is how it will return a greater profit. The great thing about it, though, is that you can even profit from it if the price of underlying security drops a little or stays the same.

This makes it an ideal strategy to use if you are confident that the price of security will increase by a small amount, but you want to try and profit if your forecast is wrong and the price in fact stays the same or drops. It shouldn’t be used if you think there’s a chance that the security will increase dramatically in price; this scenario will cost you money.

How the Call Ratio Spread is Created

The call ratio spread is, as the name suggests, a type of ratio spread, which means that the legs that are required involve unequal amount of options. This makes the strategy more complicated than a lot of the alternatives, and it’s best avoided by beginners.

There are two legs involved, which would typically be transacted simultaneously. For one leg you should buy a number of in the money or at the money call options on the relevant underlying security, and for the other leg you should write a greater number of out of the money calls on the same underlying security. Your goal is to create a credit spread, where you receive a net credit at the time of establishing it.

You need to bear this in mind when considering what ratio, and what strikes to use. The ratio is the number of calls written compared to the number bought, and between 2 to 1 and 3 to 1 is fairly standard. When you are using the strategy for the first few times, it’s probably a good idea to stick to a ratio around that level.

In terms of strikes, we would advise that buying at the money calls and writing calls at a slightly higher strike. Once you are familiar with the strategy and how it works, you can start adjusting the ratio and the strikes according to your objectives.

Below is an example of when and how you might create a call ratio spread. We have used hypothetical options prices rather than exact market data, just to provide a simple overview of how the spread can work. We have also ignored commission costs, again for the sake of simplicity.

  • Company X stock is trading at $50, and you believe it will remain at around that price or possibly increase to $52, but no higher.
  • Calls with a strike of $50 (i.e. at the money) are trading at $2. You buy 1 contract containing 100 of these options at a cost of $200. This is Leg A.
  • Out of the money calls with a strike price of $52 are trading at $1. You write 3 contracts, each containing 100 of these options, for a credit of $300. This is Leg B.
  • You have created a call ratio spread using a 3 to 1 ratio, for a net credit of $100.

Profit Potential & Risk of Loss

The maximum profit is made when the price of the security (Company X stock) is trading at a price equal to the strike of the calls in Leg B ($52 in this instance) at the time of expiration. This will result in the calls in Leg A expiring in in the money, while the ones in Leg B will expire at the money and worthless.

If the price of the underlying security rises above this level the position will start to reverse, and will turn into a losing position if the price goes too high. If the price of the underlying security stays the same price, or falls, the spread will still return a profit equal to the net credit received at the time of creating it. Let’s look at some possible outcomes.

  • If the price of Company X stock stays at $50, or falls, then the calls in both legs will be worthless at expiration. You’ll have no further returns and no further liabilities. Your profit will be the net credit received: $100.
  • If the price of Company X stock is somewhere between $50 & $52 at expiration, then the calls options in Leg B will be worthless and you will have no further liabilities. The ones in Leg A will be in the money and worth something. Your profit will be the net credit plus the value of the options owned.
  • If the price of Company X stock is at $55 at expiration, then the calls in Leg A will be worth $5 each, for a total value of $500. The ones in Leg B will be worth $3 each, for a total of $900. This loss of $400 is partially offset by the $100 initial net credit received for a total loss of $300. This loss would be greater if the price of the underlying security is any higher.

The following calculations can be used to determine how this strategy can profit, how it will return a loss and what those profits and losses might be.

  • Maximum profit is made “Price of Underlying Security = Strike of Options in Leg B”
  • Maximum profit is “((Strike of Options in Leg B – Strike Price of Options in Leg A) 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 and (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”

Summary

This spread has one particularly clear advantage, in that it can profit if the price of the underlying security either falls or stays the same and it can profit from the underlying security going up. It will only return a loss if the price of the underlying security goes too high and the value of the options written increases above the value of the ones owned.

The downside is that it’s a complicated strategy, and it can be difficult to calculate the optimal ratio to use and the best strikes to use.

Ratio Calendar Spread

Ratio Calendar Spread

Ratio Calendar Spread

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