What is Ratio Spread?
Options trading is considered one of the best ways to diversify and make low-risk profits. Every professional trader diversifies by allocating a portion of their capital to options. However, if you are still fully invested in stocks, starting options trading based on instinct with a hope to make profits is a bad idea.
Options trading indeed is one of the most profitable asset classes, but it is complex. This means that it includes many factors and strategies that you have to learn before entering the options market. This blog will provide knowledge about an options strategy called Ratio Spread and how you can utilise it to make profitable investments.
What is Options Trading?
Options are contracts that grant the holder the right but do not bind them, to either buy or sell a sum of some underlying asset at or before the contract expiration at a fixed price. Options can be acquired with brokers such as IIFL through online trading accounts as with any other asset group.
Types of Options Contract
A Call Option is a contract wherein you win the right, but not the obligation, to buy a certain underlying asset at a decided upon price and date between the contracting parties.
A Put Option works exactly opposite to the call option. The put option empowers you with the right to sell the stock at the price on the date agreed upon by the contracting parties.
Some terms associated with the Ratio Spread options
Before you jump to understand ratio spread, it is crucial to understand the following terms:
- Strike Price:The price at which the options contract was initially bought or the pre-determined price.
- In-The-Money (ITM) option:When the underlying asset price is higher than the strike price.
- Out-of-the-money (OTM) option: When the underlying asset price is lower than the strike price.
Being aware of the terms related to ratio spread strategy, read on to understand one of the most widely used options strategies.
What is the Ratio Spread Options Strategy?
A ratio spread strategy is a neutral options trading strategy in which an options trader holds an unequal number of long (purchased) and short (written) options contracts. The fundamental structure of the ratio spread strategy is the number of contracts that are held by the trader, which are always in a specific ratio.
The most common ratio in ratio spread strategy is 2:1. For example, if a trader is holding three long contracts, the short contracts will be six, bringing the ratio to 2:1.
The factors that make the ratio spread strategy similar to other spreads lie in its feature to use long and short positions based on the same options type (call or put) have the same underlying asset and the expiration date. The only difference is its ratio, which is never 1:1, unlike other spreads.
What is Call Ratio Spread?
Investors use two types of spreads within the ratio spread strategy: Call Ratio Spread and Put Ratio Spread. A Call Ratio Spread is when a trader buys call options at a lower strike price and sells a higher number of call options at a higher strike price. Here, the number of contracts that the traders buy and sell are in a specific ratio.
The idea behind the Call Ratio Spread is based on a trader’s belief that the underlying asset will moderately rise in its price soon and only up to the strike price of the sold contracts (which were higher). Traders mainly use the strategy to decrease the cost of the premium they have paid initially. However, traders can also use the strategy to receive upfront credit of premium. You can construct a Call Ratio Spread for a 2:1 ratio as follows:
- Buy 1 in-the-money call option.
- Sell 2 out-of-the-money call options.
Examples of Ratio Spread
Suppose you place a call ratio spread in ABC stock which is trading at Rs 200 with an expiration date of three months and a lot size of 100 shares. Here is how it will look like:
- Buy one call with a 210 strike price and Rs 5 premium (total Rs 500 as Rs 5x100)
- Sell two calls with a strike price of Rs 220 and Rs 3 premium (total Rs 600 as Rs 3x200)
The above transactions will give you a net credit of Rs 100 (Rs 600-Rs 500). This is the highest profit you can earn if the stock price falls and stays below Rs 210 as all the contracts will expire worthlessly. If the stock is trading between Rs 210 and Rs 220 at the time of expiry, the trader makes profits through the option positions and the net credit of the initial premium.
The maximum profit for the trader occurs if the stock price is Rs 220 at the time of the expiry. However, if the price goes above Rs 220, the trader will lose with every point of increase.
Ratio Spread is a neutral strategy that traders use to make profits if they think that the underlying asset’s price will rise moderately. However, as it is a complex strategy, you must learn about how to use it before executing effectively. Visit IIFL’s website to know more.
Frequently Asked Questions Expand All
You can calculate a Ratio Spread by calculating the potential of maximum profit, maximum loss and breakeven points after executing the trades.
Some similar strategies are Bear Call Spread, Call Ratio Back Spread, Bull Call Spread etc.
You can manage it by using an underlying asset that you think is moving higher and entering the trade after a strong bull move.