Vertical Ratio Spreads are simply vertical spreads that buy and sell an unequal number of options.
What vertical ratio spreads do is essentially to combine the directional merit of vertical spreads with the neutral and volatile inclination of ratio spreads, creating unique neutral and volatile options trading strategies that allows maximum profit or unlimited profit in one direction while establishing the vertical ratio spread positions with a net credit, which greatly reduces risk and increases the probability of win.
This tutorial shall explain what vertical ratio spreads are in options trading and outline all of the different kinds of vertical ratio spread options strategies.
Vertical Ratio Spreads are vertical spreads that buy and sell an unequal number of options. In classic vertical spreads, you will always buy and sell an equal number of options on each leg. For example, in a
bull call spread (which is a vertical spread of course), you will short as many
out of the money call options as the
at the money or
in the money call options bought. However, in a vertical ratio spread, you would short more out of the money call options than the
call options that are bought. The term "Ratio" in Vertical Ratio Spreads refers to the fact that the number of contracts on each leg conforms to a certain ratio. The most common ratio in Vertical Ratio Spreads is having 2 short options to 1 long option, what we call a 2:1 ratio spread.
Vertical Ratio spread is simply a way of classifying vertical 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.
Types of Vertical Ratio Spreads
Essentially, all vertical spreads can be converted into vertical 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 vertical ratio spreads; Call Vertical Ratio Spreads and Put Vertical Ratio Spreads.
Call Vertical Ratio Spreads are ratio spreads made up of only call options.
Call Ratio Spreads involve selling more out of the money call options than at the money / in the money call options are bought so as to create a position that profits all 3 ways with maximum profit attained when the stock goes up.
Call Ratio Backspreads involve buying more at the money or out of the money call options than in the money call options are bought in order to create a
credit volatile options trading strategy with unlimited profit potential to upside. Typical credit
volatile options strategies does not come with unlimited profit potential either way.
Put Vertical Ratio Spreads are ratio spreads made up of only put options.
Put Ratio Spreads involve selling more out of the money put options than at the money / in the money put options are bought so as to create a position that profits all 3 ways with maximum profit attained when the stock goes down. Put Ratio Backspreads involve buying more at the money or out of the money put options than in the money put options are bought in order to create a credit volatile options strategy with unlimited profit potential to downside.
The basic aim of Vertical Ratio Spreads is to create credit volatile options strategies with unlimited profit potential in one direction and also to create positions that profit in all 3 ways.
Typically, volatile options strategies put on for a net credit, like the
Short Butterfly Spread, only has limited profit potential. This means that no matter how far the underlying stock breaks out to either direction, there is a limit to the maximum profit attainable. However, Vertical Ratio Spreads overcome that limited maximum profit potential weakness of credit volatile options trading strategies by introducing unlimited profit potential in one direction and limited profit in the other direction, opening up direction for explosive profit should the underlying stock moves strongly in that direction. Taking the Call Ratio Backspread for example, if the underlying stock breaks to downside, it makes a limited profit just like the Short Butterfly Spread but if the stock breaks out to upside and continues going upwards strongly, the Call Ratio Backspread makes an unlimited profit as long as the stock continues to go up!
Vertical Ratio Spreads also overcomes the single directional weakness of vertical spreads such as the bull call spread and
bear put spread by allowing them to profit even when the stock remain stagnant or goes in the disfavorable direction! Yes, by transforming a bull call spread into a Call Ratio Spread through selling more out of the money call options, resulting in a net credit position, the position now not only profits when the stock goes up to the strike price of the out of the money call options just like in a bull call spread but also profit when the stock remain stagnant or goes down instead! Not only is the vertical ratio spread capable of profiting in all 3 directions, it also make a lot more profit than the bull call spread or the bear put spread does when the stock closes at the strike price of the out of the money options upon expiration.
More profit, more directions and more possibilities than typical non ratio spreads is what vertical ratio spreads are capable of.
Advantages of Vertical Ratio Spreads
Lowering of margin requirement when shorting near term options.
Capable of profiting in all 3 directions.
Creates the only credit volatile options trading strategy that has unlimited profit potential in one direction.
Disadvantages of Vertical Ratio Spreads
Margin is needed when shorting more options than options of the same type are bought.
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