How Does The Put Ratio Spread Work in Options Trading?
What Is A Put Ratio Spread?
A Put Ratio Spread is a vertical ratio spread with the ability to make a profit in all 3 directions; Upwards, Downwards and Sideways. Yes, all 3 directions! The Put Ratio Spread and the Call Ratio Spread are the only options trading strategies capable of profiting from all 3 directions all at once, greatly enhancing the probability of win in a trade. The only way a Put Ratio Spread can lose money is when the underlying stock drops too strongly. Because the Put Ratio Spread loses money when a stock drops strongly, it has been technically classified as a neutral options strategy even though it does not lose money no matter how much the underlying stock rises.
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When To Use Put Ratio Spread?
One should use a Put Ratio Spread when one is confident in a drop in the underlying instrument down to a certain price and wishes to make money even if the stock should remain stagnant or go upwards instead. It is a good strategy to maximise profits on stocks that are expected to hit a technical support level.
How to Execute Put Ratio Spreads?
Overview
Put Ratio Spreads are established by shorting more out of the money Put Options than the amount of in the money / at the money Put Options are bought, resulting in a credit.
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Example of Put Ratio Spread:
Assuming QQQQ at $44. Buy To Open 4 contracts of QQQQ Jan44Put @ $1.05, Sell To Open 10 contracts of QQQQ Jan43Put @ $0.60 |
In the above example, 10 contracts of out of the money options are shorted while only 4 contracts of at the money Put Options are bought. The ratio in this Put Ratio Spread is 2.5 : 1. This means that for every 1 contract of at the money Put Options bought, 2.5 contracts of out of the money Put Options are bought. This is why such options trading strategies are known as Ratio Spreads. Veteran options traders would notice by now that Put Ratio Spreads are simply Bear Put Spreads that sells more out of the money Put Options than at the money Put Options.
How to Determine Ratio and Strike Price to Use For Put Ratio Spread?
Determining the above ratio depends on which strike price the out of the money Put options are shorted. In general, the lower the strike price of the out of the money Put Options, the lower the price of each contract and hence the more contracts need to be shorted in order to result in a net credit, requiring higher margin.
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Example of Different Strike Prices Put Ratio Spread:
Assuming QQQQ at $44. Jan44Put is trading @ $1.05, Jan43Put is trading @ $0.60, Jan42Put is trading @ $0.25. If the Jan42Put is chosen for shorting instead of the Jan43Put, you would need to short 24 contracts to achieve the net credit of $180 rather than just shorting 10 contracts using the Jan43Put. Below is a comparison: ($0.25 x 2400) - ($1.05 x 400) = $180 credit using the Jan42Put Note: Each options contract represents 100 shares, therefore the figure used in the calculation is the number of contracts times 10. |
The lower the strike price of the out of the money Put Options shorted in a Put Ratio Spread, the lower the stock can drop before the position starts losing money (the losing point). So the trade off here is really the amount of margin you have versus how far you want the losing point to be. The lower the strike price of the out of the money Put Options, the farther the losing point of the Put Ratio Spread becomes. Stock options trading is all about trade-offs.
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Example of Losing Point in Put Ratio Spread:
Assuming QQQQ at $44. Below is a comparison of the losing point between shorting 10 contracts of Jan43Put vs 24 contracts of Jan42Put while long 4 contracts of Jan44Put Shorting 24 contracts of Jan42Put ($0.25 x 2400) - ($1.05 x 400) = $180 credit using the Jan42Put Shorting 10 contracts of Jan43Put ($0.60 x 1000) - ($1.05 x 400) = $180 credit using the Jan43Put Losing point = $42.03 Note: Formula for losing point will be covered below. |
The lower the strike price of the out of the money Put Options shorted in a Put Ratio Spread, the higher the maximum profit attainable by the Put Ratio Spread will be if the initial net credit is kept the same. However, that also means that the stock needs to drop more in order to attain that maximum profit as the maximum profit attainable by a Put Ratio Spread is when the stock closes on the strike price of the short Put Options upon expiration. Yes, another options trading trade-off.
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Example of Maximum Profit vs Maximum Profit Point in Put Ratio Spread:
Assuming QQQQ at $44. Jan44Put is trading @ $1.05, Jan43Put is trading @ $0.60, Jan42Put is trading @ $0.25. Below is a comparison of the maximum profit and maximum profit point between shorting 10 contracts of Jan43Put vs 24 contracts of Jan42Put while long 4 contracts of Jan44Put: Shorting 24 contracts of Jan42Put ($0.25 x 2400) - ($1.05 x 400) = $180 credit using the Jan42Put Maximum Profit = $980, Maximum Profit Point = QQQQ @ $42 Shorting 10 contracts of Jan43Put ($0.60 x 1000) - ($1.05 x 400) = $180 credit using the Jan43Put Maximum Profit = $580, Maximum Profit Point = QQQQ @ $43 Note: Formula for maximum profit will be covered below. |
In an ideal world where margin is not a concern, you would short as many out of the money Put Options as you want to as far out of the money as possible in order to build a Put Ratio Spread with the highest possible net credit, maximum profit and farthest losing point. However, such a world does not exist in options trading and margin is as big concern a in Put Ratio Spreads as it is in any options trading strategies involving uncovered short option positions.
If you only have enough margin to short a certain number of options contracts, you can either short a higher strike price or you can buy fewer at the money Put Options in order to maintain the net credit in the Put Ratio Spread. In our Put Ratio Spread examples so far, if you have enough options trading margin to short only 10 contracts, you can use a higher strike price in order to maintain the net credit of the position by choosing the Jan43Put and not the Jan42Put as 10 contracts of Jan42Put would not result in a net credit. Otherwise, you can buy no more than 2 contracts of Jan44Put and still maintain a net credit with 10 contracts of Jan42Put.
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Example of shorting a lower strike price and buying lesser Put Options in Put Ratio Spread:
Assuming QQQQ at $44 and you have enough margin to short only 10 contracts max. Jan44Put is trading @ $1.05, Jan43Put is trading @ $0.60, Jan42Put is trading @ $0.25. Scenario 1: Shorting a Lower Strike. If you can only short 10 contracts of Jan42Put, you won't be able to cover the price of the 4 contracts of Jan44Put bought at all. 10 Contracts of Jan44Put = $1.05 x 400 = $420. 10 contracts of Jan42Put = $0.25 x 1000 = $250. The position would be a net debit of $170 instead of a net credit. When a Put Ratio Spread is a net debit position, it would not be able to make any money if the stock goes down. In this case, you should short the Jan43Puts instead as illustrated in the first example in the overview above. Scenario 2: Buying lesser Put Options. In order to maintain a net credit while shorting 10 contracts of Jan42Put, you should buy no more than 2 contracts of Jan44Put. 10 contracts of Jan42Put = $0.25 x 1000 = $250 2 contracts of Jan44Put = $1.05 x 200 = $204 Net Credit = $250 - $204 = $46 |
Profit Potential of Put Ratio Spread :
The maximum profit potential of a Put Ratio Spread is attained when the underlying stock closes at the strike price of the short Put Options. In this respect, the profit potential of a Put Ratio Spread is limited.
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Maximum profit point of Put Ratio Spread:
Assuming QQQQ at $44. Buy To Open 4 contracts of QQQQ Jan44Put @ $1.05, Sell To Open 10 contracts of QQQQ Jan43Put @ $0.60 Maximum Profit happens when the QQQQ closes at $43 at expiration of the Jan43Put. |
Maximum Possible Profit Calculation of Put Ratio Spread:
Maximum Possible Profit = (Total Credit From Short Put Options + [(Difference in strikes - Price of Long Put) x 10 times number of long put contracts])
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Profit Calculation of Put Ratio Spread:
Assuming QQQQ at $44. Buy To Open 4 contracts of QQQQ Jan44Put @ $1.05, Sell To Open 10 contracts of QQQQ Jan43Put @ $0.60 Max. Return = (0.6 x 1000) + ([(44 - 43) - 1.05] x 400) = $580 |
Risk / Reward of Put Ratio Spread:
Upside Maximum Profit: Limited
Maximum Loss: Unlimited
Position will start losing money if the stock drops past its losing point. However, if the stock rises instead of
falls, then the position makes in profit the net credit gained.
Losing Point of Put Ratio Spread:
The losing point of a Put Ratio Spread is the price beyond which the
position starts to go into a loss if the stock continues to go down.
Losing Point: Strike Price of Short Put Options - [Maximum Profit / (number of short Put Options - number of long Put Options)]
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Losing Point of Put Ratio Spread:
Assuming QQQQ at $44. Buy To Open 4 contracts of QQQQ Jan44Put @ $1.05, Sell To Open 10 contracts of QQQQ Jan43Put @ $0.60 Losing Point = 43 - [$5.80 / (10 - 4)] = $42.03 If the QQQQ falls below $42.03, the position will start making an unlimited loss as long as the QQQQ continues to go lower. |
Advantages Of Put Ratio Spread :
Disadvantages Of Put Ratio Spread :
Alternate Actions Before Expiration :
1. When the underlying stock reaches the strike price of the short Put Options before expiration, one may choose to buy to close the extra short Put Options and transform the position into a Bear Put Spread in order to prevent losses due to a ditch in price past losing point.
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