Ratio Spreads in Options Trading

Views 3789 Jul 9, 2024

Options trading can offer flexible options for trading strategies, especially when traders can time their trades according to the difference between the asset’s market value and the strike price listed in the contract. A ratio spread is one such strategy, one that requires traders to purchase unequal numbers of options contracts. Though this options strategy carries some risk, it also offers the possibility of substantial rewards.

Below, moomoo explains how a ratio spread works in options trading and how traders can use it to their advantage.

What Is a Ratio Spread?

A ratio spread is a type of options strategy in which a trader buys a call or put option that is either at the money (ATM) or out of the money (OTM) while then selling at least two or more of the same OTM options. Traders can buy or sell calls (call ratio spread) or puts (put ratio spread).

The method carries risk since the asset’s stock price could move outside the strike price of the options involved in the strategic maneuver. On the other hand, the difference in the strike prices and the net credit received translates into the possibility of large returns.

How Does a Ratio Spread Work?

A ratio strategy is best used when you believe that the price of an asset is unlikely to change. However, there may be times when you use a ratio spread with a bullish or bearish approach — which requires the use of either a put ratio spread or a call ratio spread. These approaches can be further divided into front and back ratio spreads, which are explained further below.

How does a ratio spread make money? The profit potential is found in the difference between the long and short strike prices. Traders may also profit from any net credit that results from the trading strategy.

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Front Ratio Spread

In a front ratio spread, traders buy and sell options at different strike prices and expiration dates. The goal is to profit from the difference between the premiums and the money received. Unlike an ordinary spread trade, the trader will buy one option and then sell two option contracts (or vice versa). In other words, the trader will create a “ratio” by buying/selling two contracts for every one option.

Front ratio spread can be either a ratio call spread or a ratio put spread. Here’s how each method works.

Front Ratio Put Spread

In a front ratio put spread, traders purchase a put debit spread and a short put at the short strike of the debit spread. This method is often used as a bearish strategy and for a net credit to minimize risk.

For example, John decides to buy a put option that’s at the money (ATM) — though he could also have purchased an OTM option. He then sells two further OTM put options for a lower strike price and net credit overall. John has effectively minimized risk while providing the opportunity for gains through the net credit and the long position he’s created.

Front Ratio Call Spread

A front ratio call spread works similarly, though here, a trader purchases a call debit spread and a short call at the short strike of the debit spread. As before, the strategy relies on a net credit, though the call ratio spread is used as a slightly bullish strategy.

For example, John purchases a call option that’s either ATM or OTM. He then sells two further OTM call options for a higher strike price and a net credit.

Back Ratio Spread

Think of a back ratio spread as the mirror image of a front ratio spread. In a back ratio spread, traders buy more call/put options than they sell. The advantage of a back ratio spread is that it offers larger profit potential, especially with a long position. However, this method can be more expensive and usually involves two In The Money (ITM) options.

Here’s how call/put ratio spreads work.

Back Ratio Call Spread

A back ratio call spread can be used as a bullish strategy. Traders can purchase two ITM call options while selling one ATM or one OTM call option against the long options.

For example, John could sell two long ITM call options while buying a short ATM call option. By doing so, John has offset the long options’ extrinsic value, but his long position now offers unlimited earnings potential.

Back Ratio Put Spread

A back ratio put spread can be used as a bearish strategy. Traders can purchase a put debit spread and an additional long put at the long strike.

For example, John can purchase two ITM put options, then sell one ATM (or OTM) put option at a lower strike price. This method offsets the long options’ extrinsic value, though John stands to profit by the difference between the long ITM strike and the stock price itself (minus the debit paid).