A Ratio Spread is an options strategy in which an investor simultaneously holds an unequal number of long and short positions. A commonly used ratio is two short options for every option purchased.
A ratio spread would be achieved by purchasing one call option with a strike price of $45 and writing two call options with a strike price of $50. This would allow the investor to capture a gain on a small upward move in the underlying stock’s price. However, any move past the higher strike price ($50) of the written options will cause this position to lose value. Theoretically, an extremely large increase in the underlying stock’s price can cause an unlimited loss to the investor due to the extra short call.
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.
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 breakeven 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
Put Ratio Spread
The ratio spread can also be constructed using puts. The put ratio spread is similar to the call ratio spread strategy but has a slightly more bullish and less bearish risk profile.