Ratio spreads are neutral in
the sense that you don't
want the market to move much
either way once you make the
trade.
While call and put ratio
spreads can be effective
strategies when you are
expecting relatively stable
prices over the short term,
they are not without risk.
By definition, a ratio
spread involves more short
than long options. If the
trade moves against you, the
extra short option(s) expose
you to unlimited risk.
(You might want to also
review a
backspread, which is a
ratio spread that involves
more long than short
options. As such, it is a
limited risk, unlimited
reward strategy.)
Put
Ratio Spread
To create a put ratio
spread, you would buy puts
at a higher strike and sell
a greater number of puts at
a lower strike. Ideally,
this trade will be initiated
for a minimal debit or, if
possible, a small credit.
This way, if the stock
jumps, you won't suffer much
because all of the puts will
expire worthless. However,
if the stock plummets, you
have unlimited risk to the
downside because you will
have sold more options than
you bought For maximum
profitability, you want the
stock price to stay at the
strike price where you are
short options.
Example
Using Merrill Lynch (Nasdaq:
MER), we can create a put
ratio spread using
in-the-money options. With
MER Trading at $39.68 in
May, you might sell three of
the JUL 40 puts and buy one
JUL 50 put.
MER Trading @ $39.68 |
Buy |
1 MER JUL 50
Put @
$10.60 |
$1,060 |
Sell |
3 MER JUL 40
Put @ $2.40 |
($720) |
Cost/Proceeds |
$340 |
 
In this case, you would pay
a $340 debit for putting on
the trade. If the stock
jumped above 60, you would
only lose the $340 paid for
the spread. However, the
real money would be made if
the stock stayed right
around $40. Here, the short
40 puts would expire
worthless and the long 50
put would be worth $10. The
value of the 50 put, minus
the initial $350 debit would
bring the net profit up to
$660.
A big move to the downside
in this case would spell
trouble. The downside
breakeven point occurs when
the stock price equals
36.70, below this point the
risk is unlimited.
* The profit/loss above does
not factor in commissions,
interest, or tax
considerations. |