A typical ratio spread is an options strategy designed to profit from nonvolatile market activity, although the reverse is true for backspreads. This strategy is basically a neutral strategy with a slight bullish or bearish sentiment. A ratio spread trade involves buying and selling unequal amounts of options at different strike prices. The position remains profitable if the price of the underlying asset remains within the strike prices selected. A ratio spread can be designed in many other ways.
The configuration of a ratio spread is virtually unlimited because of the available strike prices and unlimited ratios that could be selected. The strategy can be a credit spread or a debit spread resulting in a net credit or debit to the investor respectively. The investor wishing to trade ratio spreads should use option software programs with graphical representations of possible outcomes.
Options strategies, including ratio spreads, fall into one of three main categories. They can be bullish, bearish or neutral. A bullish strategy anticipates a positive price movement in the asset. A bearish strategy anticipates a negative price movement in the underlying asset. A neutral strategy anticipates little or no movement in the price of the underlying market.
The ratio spread using call options is typically a vertical spread. The investor buys a number of calls at a lower strike price and sells more calls at a higher strike price. The theoretical upside risk is unlimited, and the downside risk is limited. Maximum profit is achieved at expiration if the price of the underlying is at the upper strike price selected.
The reverse call ratio spread is more commonly used. The investor sells a call at one strike price and buys several calls at the higher strike price. This strategy anticipates a large price movement in the underlying asset. This trade is normally initiated as a credit spread. The maximum downside profit is limited to the credit received. The maximum upside profit is theoretically unlimited.
The typical put ratio spread involves buying a number of puts and selling a greater number of puts at a lower strike price. The maximum profit is realized at the lower strike price. The theoretical downside risk is unlimited, and the upside risk is limited. This spread strategy can also be reversed, creating a different set of break-even points and profit/loss scenarios. Reverse spreads are also known as backspreads.
A ratio calendar spread or diagonal ratio spread involves buying and selling options with different expiration dates and strike prices. The risk associated with these complex strategies can vary. The diagonal ratio spread can be constructed to capitalize on trending markets and breakout markets. This strategy causes a loss if the stock sharply breaks down in the opposite direction of the anticipated bias.
Trading ratio spreads requires education and experience in options trading. Options trading software must be used to calculate the possible risks and rewards of the ratio spread being configured. Ratio spreads are versatile strategies that can be very complicated. Factors such as volatility will affect the outcome greatly.