Ratio Spreads Option Strategy
A ratio call spread is
similar to a call spread but more calls
are sold than bought. For example, the purchase
of one January 100 call for $5 and the sale of 2
January 105 calls for $3 is a 1 by 2 ratio call
spread. This ratio is termed a 1 by 2 call spread
because 1 call is bought for every 2 calls sold.
Ratios may be done in any proportion such as 1 by 3
or 2 by 3. In this example, the buyer receives $1
for each spread because $6 is received from the 2
calls sold for
each $5 paid for the
1 call bought ($6
-
$5
=
$1). These spreads
may be done
for debits or credits.
The profit and loss potential in the present
will not be shown for the remaining spreads because
it is highly dependent on the volatility and time to
expiration of the options. For example, assume the
market is trading at 95 and suddenly moves to 105.
Ratios with options of a long-term expiration will
probably lose money because the volatility increase
may make the 105 calls increase in value much more
than the 100 calls. However, ratios with options
that expire in a week will probably become
profitable because the 100 calls will more likely
increase in value much more than the 105 calls.
An investor buying a ratio may expect the market to remain where it is,
or rally slightly. Unlike the previous spreads, the
profit is limited, but the loss is potentially
unlimited if the market rises sharply. A person
employing this strategy is accepting the unlimited
risk on the upside, for the possibility of making
more money than a 1 by 1 call spread if the market
closes at the 100 strike. The downside risk is not
as great with a ratio spread as with a 1 by 1 call
spread, and if the spread is done for a credit the
trader may make money if the market falls.
A ratio put spread
is
similar to
a put
spread but
more puts are sold than bought.
Buying 100 put for $5
and selling on 95 puts for
$2 is an example of a 1 by 2 ratio put spread. This
spread is done for a $1 debit because only $4 from
the 95 puts is received for the $5 paid
for each 100 put.
Ratio
put spreads are purchased for exactly the
opposite reason the ratio call spread is bought.
The investor expects the market to drop, but in
a relatively stable manner. Since
this spread is done for a debit, the investor
will lose money if the market rallies.
A
Christmas tree
is another variation of ratio call and put
spreads. A Christmas tree is the buying of one
call, selling one call at the next higher
strike, and selling one call at the next higher
strike. Buying one December 100 call, selling
one December 105 call, and selling one December
110 call is an example of buying a Christmas
tree. The profit and loss profile is somewhat
similar to a 1 by 11/2 ratio spread, depending
on how far apart the strikes are and how close
to expiration the trade is done. The strategy
for purchasing a Christmas tree would be similar
as for any ratio spread-a steady move upward or
the market staying in the same area. Selling a
Christmas tree would involve buying the two
higher strikes and selling the lowest strike.
Christmas trees may be done with puts too.
Ratio Spreads Option Strategy
