2 Ratio Spread

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 strikeprice. 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.

Ratio Spread Construction

Buy 1 ITM Call Sell 2 OTM Calls

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

Ratio Spread Payoff Diagram

Unlimited Upside Risk

Loss occurs when the stock price makes a strong move to the upside beyond the upper beakeven 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

Using the graph shown earlier, since the maximum profit is 500, points of maximum profit is therefore equals to 5. Adding this to the higher strike of 45, we can calculate the breakeven point to be 50. (See example below)

Example

Suppose XYZ stock is trading at 43 in June. An options trader executes a 2:1 ratio call spread strategy by buying a JUL 40 call for 400 and selling two JUL 45 calls for 200 each. The net debit/credit taken to enter the trade is zero.

On expiration in July, if XYZ stock is trading at 45, both the JUL 45 calls expire worthless while the long JUL 40 call expires in the money with 500 in intrinsic value. Selling or exercising this long call will give the options trader his maximum profit of 500.

If XYZ stock rallies and is trading at 50 on expiration in July, all the options will expire in the money but because the trader has written more calls than he has bought, he will need to buy back the written calls which have increased in value. Each JUL 45 call written is now worth 500. However, his long JUL 40 call is worth 1000 and is just enough to offset the losses from the written calls. Therefore, he achieves breakeven at 50.

Beyond 50 though, there will be no limit to the loss possible. For example, at 60, each written JUL 45 call will be worth 1500 while his single long JUL 40 call is only worth 2000, resulting in a loss of 1000.

However, there is no downside risk to this trade. If the stock price had dropped to 40 or below at expiration, all the options involved will expire worthless. Since the net debit to put on this trade is zero, there is no resulting loss.

 

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