The ratio spread is one of the most underrated strategies which can have infinite risk-reward. It also can give ‘rewards only’ if one understands how to adjust it properly. There are multiple adjustments possible for this strategy. Ratio spread strategy can be built for calls and puts. In this blog, we have explained ratio spreads in detail. By going through this blog you will get a complete understanding of ratio spreads.
This Blog Covers,
What are spreads in options?
What is a ratio spread strategy?
Call ratio spread strategy
Call ratio spread payoff
Ratio spread strategy Adjustments
What Are Spreads In Options?
Before knowing ratio spread strategy, let's understand first what are spreads in options? An options trading strategy in which a trader buys and sells multiple options- either call or put of the same type with the same underlying asset, is called spread in options. These options are similar but they have different strike prices, expiry dates, or both.
What Is A Ratio Spread Strategy?
Now you know what are spreads in options, let's understand ratio spread. A ratio spread is a strategy in which an investor holds an unequal number of long and short or written options both at the same time. It is a neutral options strategy whose name comes from the trade structure where the number of short positions to long positions has a particular ratio. Two to one (2:1) is the most common ratio in the ratio spread strategy where there are twice as many short positions as long.
This strategy is similar to a spread strategy where there are short and long positions of the same options type (put or call) on the same underlying asset. But the only difference between these two strategies is that the ratio is one-to-one in spread strategy and two to one in ratio spread strategy.
A ratio spread involves buying an ATM or OTM call or put option and selling of the two or more same options of further OTM. Following are the two types of ratio spread strategy,
1. Call ratio spread strategy : - This strategy refers to buying and selling CALLs.
2. Put ratio spread strategy : - This strategy refers to buying and selling PUTs.
In this blog, we are going to see the call ratio spread strategy in detail.
Call Ratio Spread Strategy
In the call ratio spread strategy you buy a lower strike call and sell more than one higher strike call. The ratio is 1:2 in the case of 1 buying and 2 selling.
If one buys 1 trade and sells 3 the ratio would be 1:3. In, the call ratio spread strategy ratio can be 2:3 or even 1:3 depending upon market conditions. Generally, a call ratio spread strategy is created with little credit or almost very small debit to keep trade risk free for downside moves.
Call Ratio Spread Payoff
See the figure below, this is the payoff chart of ratio call spread strategy.
As can be seen from the image, this strategy gives profit from a modest rise in the underlying price. When the price of underlying increases and reaches the higher strike price, then maximum profit is achieved. Once the underlying price goes beyond the higher strike price the profitability starts reducing.
If you see the payoff graph of the call ratio spread then you will notice that, when the underlying price crosses above the breakeven point, the trader will start getting losses.
Also, observe that because this strategy is established as a net credit strategy, even if the underlying price drops below the lower strike price the trader will going to get the profit only.
In this case, no matter how lower the underlying price drops below the lower strike price, the maximum profit will be limited to the extent of the net premium. For big upside moves an unlimited risk is there. Therefore adjustments are very important. Now let's see what those adjustments are.
Ratio spread strategy Adjustments
1. Decrease The Ratio
If you have created a strategy with 1:2 or 1:3 and if a big up-move occurs, then the ratio can be reduced to 1:1.5 with an ultimate aim to bring it to 1:1. Once it is 1:1 at right time, it gets converted to bull call spread, and hence the risk of loss due to an up-move gets mitigated. Now the question arises is that how to be 100% sure on when to do this? There is a clear mathematical formula up to which you can decrease the ratio. One must follow it very strictly to nullify any risk on big up-moves.
2. Covert the spread into the butterfly
In case of a big up-move, higher strike call can be purchased to convert the ratio of 1:2 into a 1:2:1 butterfly spread. A ratio spread of 1:2:1 means purchasing 1 call, selling 2 calls and again purchasing 1 Out of The Money (OTM) call.
By doing this an unlimited risk of the trade will be reduced to a defined risk. One should know when to convert the trade into a butterfly so that trade is under control and doesn't lose its inherent advantage.
3. Break the trade
Many of the times 1:1 ratio becomes always profitable than the 1:2 ratio. This adjustment is for up-move as there is no point in doing adjustment in the down move because there is no risk involved in the down move. The ratio 1:1 is always profitable because it's the bull call spread and what happens in 1:2 is that the second sold call is naked and exhibits high chances of loss. Therefore in big moves, this second call needs to be broken into a strangle; so that you get much better space upside. This will ensure profit in the 1:1 part. Also ensures no loss in the 2nd naked call and hence overall trade can still be profitable.
From this blog we can conclude some facts about ratio spreads is that, no downside risk is there, the margin required is around 1 lakh and the percentage of profit is very high. Unlimited loss is also possible for ratio spreads but percentage return can be attractive. If the price makes a large move to the upside, then loss occurs for the call ratio spread because the trader has sold more positions than they have long. We hope you have got a complete understanding of what are spreads in options, what is the call ratio spread strategy, and how to adjust ratio spread strategy to mitigate upside risk.