Discover the advantages and risks of implementing an options put ratio spread strategy to help pursue your specific financial objectives.
Ready for a primer on put ratio spreads? Take a deep breath and let’s dive in.
For option traders, basic spreads are typically created on a ratio of 1:1. A vertical spread has one long option for every short option. A typical straddle or strangle consists of the purchase (or sale) of a call and the purchase (or sale) of an equal number of puts with the same expiration date.
But ratio spreads, as the name implies, don’t. And although they come in all shapes and sizes, a good place to begin is with a basic 1:2 put ratio spread (or “one-by-two put spread” in trader-speak).
A standard put ratio spread consists of the purchase of a (long) put and the sale of twice as many (short) puts. For example, a common one-by-two put spread includes purchasing an out-of-the-money (OTM) put and selling two OTM puts of a lower strike. Think of it as a put vertical spread with the sale of an extra put at the lower strike. And as we’ll see, adding that extra put makes the risk profile look a lot different than a put vertical spread.
In fact, it’s sometimes possible to open a put ratio spread for a credit by collecting more on the sale of the two lower-strike puts than is paid to purchase the higher-strike put.
Here’s one rationale behind the put ratio spread. Suppose a trader has their eye on a certain stock and is thinking “I don’t want to buy it at the current level, as it looks ripe for a slow drift downward, but if it gets below a certain price, I’d consider buying.”
In the figure above, you can see that the put ratio spread for a credit is designed for just such a scenario. If the stock stays where it is or goes up and the options expire worthless, the trader will likely keep the net premium, minus transaction costs. If it drifts down to the short put strike at expiration, the spread reaches the point of maximum profit. If the stock continues down past the short strike at expiration, the trader will likely be left with a long stock position after exercise and assignment.
In other words, with a put ratio spread, the option trader better be comfortable buying stock (at that lower strike price) because that’s the risk that comes with the strategy. This means that selling the extra put exposes traders to the risk profile of a long stock position if the stock is below the lower strike and the put is assigned at or before expiration. And like any long stock, the maximum downside risk is the stock falls all the way to zero.
The image below shows a stock trading at $71. Using options with 32 days to expiration, a put ratio can be created by buying one 70 put for $6 and selling two 65 puts for $3.50, for a combined net credit of $1 ($6 – $3.50 – $3.50), minus transaction costs. One way of thinking about this trade is buying a 70-65 put vertical for $2.50 ($6 – $3.50 = $2.50) and collecting $3.50 by selling a 65 put, thus giving the $1 credit.
As you can see in the figure above (blue line shows the profits and losses at expiration), if the stock falls below $70, the profit on this spread increases all the way down to the $65 level (1), which is when the short strike is at the money (ATM), meaning the stock price equals the strike price. Then the trade starts to give up profits as the stock moves below $65 (2). That is, the losses on the extra short put are beginning to offset the gains in the long put vertical spread, which reaches a maximum at $65 at expiration.
Remember: The put ratio is essentially a long vertical put spread with an extra short put.
To calculate the break-even point (3), first take the width of the strikes, or 70 – 65 = 5. Then, subtract that number from the lower strike of 65, or 65 – 5 = 60. Lastly, subtract the $1 credit from selling the spread for a break-even point of $59, excluding transaction costs.
And what if the stock goes up? If the stock holds above $70 (strike price of the long put), all the puts will likely expire worthless, and the trader is left with the $1 (which is $100 per spread because the options multiplier is 100), minus transaction costs.
In general, the higher the implied volatility of the options when initiating the trade, the higher credit received (depending on the strikes selected, of course). When volatility is lower, the opposite will likely be true.
In the example above, if an option trader is comfortable taking the risk of buying stock at $65, or about 8.5% lower than its current price, this might be a strategy to consider.
In general, when deciding on ratio spread strikes, some traders look for a point where they’d be comfortable buying a stock below the current market price and consider using that price as a short strike. Then, they might choose a long strike that is OTM but closer to ATM. The closer the long strike is to ATM, the less of a net credit (or the higher the debit).
But that’s the thing about ratio spreads—it’s all proportional.