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How Do Horizontal Ratio Spreads Work in Options Trading?

Horizontal Ratio Spreads - Introduction

Horizontal Ratio Spreads are simply Horizontal spreads that buy and sell an unequal number of options. Like all Horizontal Spreads, the Horizontal Ratio Spread profits primarily from the difference in time decay between the short term options and longer term options on a neutral outlook. However, unlike the Horizontal Spread, Horizontal Ratio Spreads are capable of returning a profit if the stock should suddenly go in one direction, just like a Vertical Ratio Spread. This allows Horizontal Ratio Spreads to achieve a higher profitability as well as a higher chance of profit than conventional Horizontal Spreads.

Horizontal Ratio Spreads - Content

What are Horizontal Ratio Spreads | Comparisons | Types of Horizontal Ratio Spreads | Purpose of Horizontal Ratio Spreads | Advantages and Disadvantages

What are Horizontal Ratio Spreads?

To understand what Horizontal ratio spreads are, you need to first learn about Horizontal spreads and ratio spreads. Go do that now.

Horizontal Ratio Spreads are Horizontal spreads that buy and sell an unequal number of options. In classic Horizontal spreads, you will always buy and sell an equal number of options on each leg. For example, in a Calendar call spread, you will short as many near term at the money call options as the longer term at the money call options bought. However, in a Horizontal ratio spread, you would short more near term call options than the longer term call options that are bought. The term "Ratio" in Horizontal Ratio Spreads refers to the fact that the number of contracts on each leg conforms to a certain ratio. The most common ratio in Horizontal Ratio Spreads is having 2 short options to 1 long option, what we call a 2:1 ratio spread.

Horizontal Ratio spread is simply a way of classifying Horizontal spreads that buys and sells an unequal number of contracts simultaneously. Knowing or not knowing such classification does not actually affect your options trading in anyway as long as you are familiar with the specific options trading strategy that you are using.

Comparing Horizontal Ratio Spreads Against Diagonal Ratio Spreads

Comparing with Diagonal Ratio Spreads, Horizontal Ratio Spreads are quite the same except for the fact that options of the same strike price are used. In Diagonal Ratio Spreads, out of the money options are written instead. Doing so allows the Horizontal Ratio Spread to produce a higher return than the Diagonal Ratio Spread if the stock remained stagnant. This is because at the money options contain more extrinsic value than out of the money options. This is the main advantage of Horizontal Ratio Spreads versus Diagonal Ratio Spreads. The disadvantage of the Horizontal Ratio Spread is that its losing point would be much closer than in the Diagonal Ratio Spread.

Comparing Horizontal Ratio Spreads Against Horizontal Spreads

There are 2 main advantages of using Horizontal Ratio Spreads versus Horizontal Spreads; Higher profitability and dual directional profit. Both of these advantages stem from the fact that Horizontal Ratio Spreads are usually set up as credit spreads by selling to open enough short term options to result in a net credt.

Because more short term options are written, Horizontal Ratio Spreads would naturally make more profit than a convention Horizontal Spread when the underlying stock remained stagnant. Also because more short term options are shorted, resulting in a net credit, Horizontal Ratio Spreads are also capable of making the net credit as profit when the stock rallies or drops in one direction, setting the position up for dual directional profits. For example, Call Horizontal Ratio Spreads are not only capable of returning the difference between the extrinsic value of the short term call options and the longer term call options as profit, it is also capable of capturing the net credit as profit if the stock goes down.

Types of Horizontal Ratio Spreads

Essentially, all Horizontal spreads can be converted into Horizontal ratio spreads just by buying and shorting an unequal number of options on each leg. It is one of the things that gave options trading its unique flexibility. There are 2 broad types of Horizontal ratio spreads; Call Horizontal Ratio Spreads and Put Horizontal Ratio Spreads.

Call Horizontal Ratio Spreads are Horizontal ratio spreads made up of only call options. Call Horizontal Ratio Spreads involve selling more near term call options than longer term call options are bought in order to not only profit from time decay but also when the stock goes down instead. Call Horizontal Ratio Backspreads involve buying more near term call options than longer term call options are shorted in order to create a short backspread with unlimited profit potential to upside. Typical credit volatile options strategies does not come with unlimited profit potential either way.

Put Horizontal Ratio Spreads are Horizontal ratio spreads made up of only put options. Put Horizontal Ratio Spreads involve selling more near term put options than longer term put options are bought in order not only to profit from time decay but also when the stock goes upwards instead. Put Horizontal Ratio Backspreads involve buying more near term put options than in the money put options are shorted in order to create a credit volatile options strategy with unlimited profit potential to downside.

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Purpose of Horizontal Ratio Spreads

The basic aim of Horizontal Ratio Spreads is to increase the profitability of the Horizontal Spread and also to add protection through its ability to profit should the stock move strongly in one direction.

A typical Horizontal Spread suffers when the underlying stock moves out of its neutral outlook. For example, a Calendar Call Spread would lose money if the stock goes up or down beyond its upper or lower breakeven point. However, a Call Horizontal Ratio Spread would lose money only if the stock goes up beyond its losing point. Other than that, if the stock remains stagnant or moves downwards instead, a profit would result.

This is why if your options trading account margin allows, you would always choose to execute Horizontal Ratio Spreads instead of conventional Horizontal Spreads.

Advantages of Horizontal Ratio Spreads

Lowering of margin requirement when shorting near term options.

Profits in more than one direction.

Creates credit volatile options trading strategies that has unlimited profit potential in one direction.

Higher maximum profit than conventional Horizontal Spreads.

Disadvantages of Horizontal Ratio Spreads

Margin is needed when shorting more options than options of the same type are bought.

Closer losing point than Diagonal Ratio Spreads or Vertical Ratio Spreads.

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Horizontal Ratio Spreads