DEFINITION of Ratio spread
The ratio spread is a neutral strategy in options trading.
It involves buying a number of options and selling more options of the same underlying stock. And expiration date at a different strike price.
WHAT IT IS IN ESSENCE
It is a limited profit, unlimited risk options trading strategy. It comes when the options trader thinks that the underlying stock will experience little volatility in the near term.
The ratio spread strategy is a variation of the option spreads strategy.
The difference between the two is in the ratio of buy to sell positions: in a ratio spread the ratio is always unequal, in an option spread they are equal.
In most ratio spreads, the trader sells two options for every option purchased. Ratio spreads can be used with either call or put options.
It will probably return a profit in the following situations:
- When the options being used are falling in implied volatility
- When the underlying asset’s price moves steadily in the trader’s favor
HOW TO USE
The most common rationale is to buy some options on a directional speculation. And finance the purchase with the sale of options that are further out-of-the-money.
Many investors seek to do a ratio spread for a credit, but to do so might mean in some instances that the ratio has to be quite steep.
Since the options that the investor is selling are cheaper than the options he is buying, he has to sell more to recoup most of, all of, or even a greater amount than the purchase cost of the long option.
That can lead to an extremely risky position. It is usually unwise to have a ratio spread with a ratio greater than 1 by 2.
Never get comfortable or complacent with ratio spreads. Call ratio spreads lose money when the stock price rises sharply; put ratio spreads lose money when the stock price drops sharply.
Monitor ratio spreads frequently and has a plan that can be enacted at a moment’s notice to neutralize the risk.
Be prepared for the worst. It is the spread that finishes careers.