What is it?
The whole concept of ratio spread can be deduced from the words it is made of. There are two types of ratio spreads- call ratio spread and put ratio spread. We will be discussing the call spread option in this article. Let’s break it down to have a better understanding. Sometimes, a trader buys and sells options at the same time and the difference between their strike prices is known as the spread. For example, if a trader buys option ATM (at the money) call at $100 and sells ATM call at $120 the spread is $20. But it’s not always buying one and selling one or vice versa. A trader often juggles with the number of buys and sells. This is when the ratio comes into play. If a trader is buying one option and selling two, it will be called 1:2. There can be as many combinations as one would like but 1:2 and 1:3 are the most preferred ones in this strategy. And if the trades are on the calls side, it will be call ratio spread, else put ratio spread.
When does it work the best?
A call option spread is mainly used in a sideways market when a stock is less volatile and is expected to move only to a certain level. A trader can suffer huge losses when the stock overshoots. This strategy is not suitable for beginners as it involves making lots of adjustments along the way. The main idea is to create a net credit spread. The ratios are adjusted according to the premiums at the respective strike prices.
Let’s understand this with an example. Say, the Apple stocks are trading at $115 and you don’t think it will go beyond $120 over the next month. Here is how you can create a call ratio spread to make the most out of it:
• An ATM (at the money) buy call of 1 contract (100 shares) at the strike of $115 for a premium of $5. This will amount to a debit of $500. Let’s call it Trade A.
• If the trade goes against the plan, you will be losing $500. So, you sell 3 contracts at strike $120 for a premium of $2 each, which amounts to a credit of $600. Let’s call it Trade B.
Hence, you create a net call ratio spread of credit $100 and a ratio of 1:3.
Profits and risks
• Let’s say the stock came down from $115. Trade A will be deemed worthless. However, Trade B will earn you a premium of $600 and the net profit will be $100.
• What happens if the stock trades above $115, say at $117? In this case, both the trades will earn profits. The net profit will be $800($200 from Trade A + $600 from Trade B).
• What if it trades at $118? The net profit will be $900($300 from Trade A + $600 from Trade B).
• Let’s say the stock is trading at $120. The net profit will be $1100($500 from Trade A + $600 from Trade B).
• Let’s say the Stock overshoots and is trading at $122. The net profit will be $200($700 from Trade A-minus $600 from Trade B plus $100 premiums).
• Let’s say the stock is trading at $123. The net profit will be $0($800 from Trade A-minus $900 from Trade B plus $100 from premiums).
Here, as you can see the profit is the first constant at $100 until the price strikes $115. It starts increasing thereafter and peaks at the strike price of $120. After that, it starts declining and breaks even at $123. After this point, the spread starts making losses.
The bottom line
It is a good strategy to use when the volatility is low. However, one should be very careful while choosing the ratio of a spread. Also, one should be in a position to make necessary adjustments along the way. As it is evident from the image of how a profit of $1100 can even turn into losses if not managed well. Lastly, this strategy is not for beginners. Volatility trading strategies can be more suitable in the nascent stage of one’s options trading career.
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