Ratio spread strategies are among the highly useful but underrated options trading strategies. These strategies involve entering long and short options positions. Ratio spreads are highly rewarding strategies, but when executed with accuracy. Therefore, it is important to fully understand these strategies before employing them in real trading.
If you want to learn about ratio spread strategies, then you are on the right platform. In this article, we are going to explain both call ratio spread and put ratio spread in the easiest words. Let’s begin right away.
Ratio spread strategies
Ratio spread strategies are among neutral options trading strategies that involve buying and selling long and short options respectively. Additionally, the underlying security and the expiry date must also be the same. Whereas, the number of options must not be equal and it is decided according to a particular ratio. These strategies are known as ratio spread because of the trade structure based on a ratio.
The ratio between long and short options varies from trade to trade. However, 2:1 is the most used ratio where traders sell two short options and buy one long option. Similarly, if a trader goes for four short options, he/she will have to buy 2 long options to keep the spread ratio to 2:1. Furthermore, there are two types of ratio spreads strategies.
1. Call ratio spread
Call ratio spreads involves buying call options at a lower strike price and selling off a different number of call options at a higher strike price. The number of both types of call options bought and sold depends on a particular ratio. Moreover, the underlying security and the expiry date must also be the same. Although this is a neutral options trading strategy, it pays off perfectly in slightly bullish market conditions.
2. Put ratio spread
Put ratio spreads involves buying put options at a higher strike price and selling off a different but higher number of put options at a lower strike price. Again, the number of both types of put options bought and sold depends on a particular ratio. Moreover, the underlying security and the expiry date must also be the same. It is the opposite of the call ratio options trading strategy because it pays off perfectly in slightly bearish market conditions.
Example for better understanding
Let’s try to better understand a ratio spreads strategy with the help of an example. Suppose you decide to employ a call ratio spread strategy for stocks of a company trading at $50 per share. Firstly, you have to buy a call option with, say, a strike price of $55 and a $2 premium. Secondly, you have to sell two call options with a strike price of $60 and a $1 premium. Now, if the price stays below $55, you will earn maximum profit which is equal to the difference between premiums paid and received.
How to adjust your strategy after initiation
You can also adjust the ratio spread strategy after initiation if things went wrong. However, the key is understanding when and how to look for adjustments. Here are the ways to adjust.
1. Decrease the ratio
When the price of the underlying security rises, you can decrease the ratio to limit your losses. Suppose that you are in the position with 1: or 1:3, you can reduce the ratio to 1:1.5 or even lower. A 1:1 ratio turns a ratio spread into a bull call spread and thus reduces the risk of loss because of an increase in the spot price.
2. Butterfly conversion
You can also go for butterfly conversion by completing a fourth transaction. Thus the new ratio will be 1:2:1. That means you are holding 1 call, selling 2 calls, and then buying 1 out-of-the-money call option. This is a great way to limit losses from an unlimited loss potential.
3. Break trades
Always remember that 1:1 is better than 1:2 when the price of the underlying security rises significantly. Getting rid of the second naked sold call is important because that second sold call is naked and exposes you to huge loss potential. The idea is to turn the ratio spread into a strangle to make overall trade a profitable one.
Ratio spread strategies are highly rewarding strategies during somewhat neutral market conditions. These strategies involve buying and selling of call or put options of the same underlying security with the same expiry date. The number of options bought and sold depends on a particular ratio. The most widely used ratio is 1:2. Always remember that these strategies are highly rewarding only when executed perfectly. Otherwise, you may lose a lot of money. Furthermore, it is also possible to adjust your ratio spread strategy in case of the market going against you. However, you need to understand how and when to go for adjustments.