What Is Put Ratio Spread?
Options trading provides a way for traders to speculate on the movement of individual stocks without the hassles of owning them. Ratio spread is an options trading strategy where a speculator adopts long and short options positions while taking limited risks. Primarily, there are two types of ratio spreads—call ratio spread and put ratio spread.
In this blog, we will explore the details of the put ratio spread.
What Is Put Ratio Spread?
First, let us understand the meaning of put ratio spread. It is a neutral strategy in options trading. A trader can adopt this strategy if they feel that the underlying security will undergo minimum volatility in the coming days.
The main concept of this strategy involves the trader buying a certain number of put options and selling more put options with the same expiration date and underlying securities at different strike prices.
A put ratio spread enables a trader to earn profits when the price of stocks spirals down. However, there might sometimes be situations when the put ratio spread generates profits even if the underlying stock’s price remains the same or moves up. This strategy can prove to be an ideal one even when there is little market movement.
The number of long and short positions in the put ratio spread is uneven. Generally, it is in the 2:1 range. In other words, there is a long position for every two short positions. But, please note that traders can use a ratio depending on their needs, i.e. they use a 4:1 or 3:1 ratio to set up their put ratio spread.
Put ratio spread is also referred to as ratio put spread, ratio bear spread or bear ratio spread.
When Should You Initiate Put Ratio Spread?
If you are a trader and wish to employ a put ratio spread, you can consider employing this strategy if you feel the underlying securities will fall moderately till the strike price in the near future. You can use this strategy to lower the upfront costs of premiums. Moreover, in certain situations, you can receive upfront credit,
How to Set Up a Put Ratio Spread?
If a trader wishes to undertake a put ratio spread strategy, they need to do the following:
- Buy 1 lot of ATM (at-the-money) or ITM (in-the-money) put option
- Sell 2 lots of OTM (out-of-the-money) put options
Considering the number of puts a trader sells is twice the number of puts they buy, the strategy is primarily a 2:1 approach. A risk-defined position with limited potential for profits is, often, the result of a put ratio spread strategy. The main aim of this strategy is to close strike prices at short strikes upon expiry.
Usually, when the short contracts expire, they are devoid of any value. On the other hand, traders can sell long contracts with maximum intrinsic value. If the price of the underlying stock or security rises above the long strike price, the options will expire without any value. In this case, the amount paid as a premium would be realised as a loss.
However, if the stock shows a bearish movement, this strategy may generate high but limited profits as long as its price does not fall beyond the lower strike price. If the underlying asset continues to fall, the potential losses can be unlimited.
Please note that your debit or credit will depend on how far in-the-money your long puts are and how far out-of-the-money your short puts are, with respect to underlying stock prices.
How Does a Put Ratio Spread Work?
Before delving into the explanation of how a put ratio spread works, let us understand a few points:
- Suppose a trader has a bearish outlook on the stocks of a company. The shares are trading at ₹550. But the trader doesn’t expect stock prices to fall below ₹500.
- To benefit from this situation, the trader sets up a put ratio spread.
- Two important points to take into account are the lot size and expiry date. The lot size of the options of this stock is 1200 and their expiry date is May 2024.
To set up a put ratio spread strategy, a trader has to do as follows:
- They have to sell 2 lots of OTM put options at a strike price of ₹500. Let us assume that the premium for the put option is ₹4 per share. Upon selling 2 lots, i.e. 2400 shares of OTM put options, the trader will receive ₹9,600 (4 X 2400).
- The trader will also buy 1 lot of ATM put options at a strike price of ₹550. Suppose the put option’s premium is ₹15 per share. To purchase 1 lot of ATM put options, the trader would have to pay ₹18,000 (15 X 1,200).
So, the total amount that this trader has to pay for the two options trade will be ₹18,000 – ₹9,600 which is ₹8,400.
So what does this mean? The trader has bought a put option of one lot ATM whereby, if the stock price falls, they will be able to sell the same at the put option price or at INR 550 itself.
Similarly, the options they will sell at OTM would mean that if the price falls or rises, they will have to sell them at INR 500.
Now, let us check how this trading strategy would work in a couple of scenarios:
Scenario 1: Share Price Falls Below ₹500
Let us assume a scenario where the price of shares falls below ₹500 and becomes ₹470 on expiry. The ATM put options that a trader bought would generate a profit of ₹550 – ₹470 = ₹80 per share. How so? While the price has dropped to INR 470, he purchased a put option where irrespective of the fall, he can sell the stock at INR 550. So while the market goes down, he still makes a profit.
So, the total profit would become (₹80×1200) = ₹96,000.
Two lots of OTM put options that the trader sold off would translate to a loss of ₹30 per share (₹500 – ₹470). So, the total loss would be ₹30×2,400 = ₹72,000. Basically, where he has sold put options, means what stocks he purchased at INR 500, he is selling at INR 470, hence he suffers a loss of INR 30 per share.
In this particular scenario, if the trader employs a put ratio spread, their total profits would be ₹15,600 (₹96,000 – ₹72,000 – ₹8,400).
Scenario 2: Share Price Remains ₹500
Let us assume a scenario where price of a stock does not fall below ₹500 on expiry date. In such a situation, the ATM put options that a trader purchased would generate a profit of ₹50 per share (₹550 – ₹500). Total profit would be ₹50×1200 = ₹60,000.
In contrast, two lots of OTM options that the trader sold would expire devoid of any value because their strike price was the same as their spot price.
In this scenario, the total profit by using a put ratio spread would be ₹51,600 (₹60,000-₹8,400).
Scenario 3: Share Price Rises above ₹550 or Stays at ₹550
Now, let us assume a situation where the share price stays at exactly ₹550 or rises above it. Two things can happen. Either, the ATM options would expire without any value or the two lots of OTM options that the trader sold would also expire without any value.
Total loss from the put ratio spread in this scenario would be ₹8,400. It is the net premium that the trader has paid for this particular options trade.
When traders have a bearish outlook, they consider using a put ratio spread which is also known as a bear ratio spread. In this blog, we have touched upon important details about this options trading strategy which was designed to deliver profits when share prices move down slightly. However, with bullish movements, the options bought would expire worthless.
Frequently Asked Questions
What is a long ratio spread?
When one short and two long calls with a higher strike price but the same expiration date are matches, a long ratio spread takes place. This strategy is a long call and a bear call spread. The strike price of a long call is equal to the upper strike price of a bear call spread.
Do ratio spreads generate profit?
Traders may profit if they use front ratio spread even if the underlying financial instrument moves the strikes OTM or ITM. But, there is an unlimited risk of losses if the prices of underlying securities rise higher than the strike price of short options.
What is put ratio back spread?
A trading strategy which involves buying two OTM (Out-of-the-Money) put options and selling one ITM put option is called a put ratio back spread. Some common ratios that traders use include 2:1, 3:1 or 3:2. An important point to remember is that it is a three-legged bearish strategy where one buys and sells options in different ratios.
What is bull ratio spread?
Traders who have a bullish outlook can employ the strategy of bull ratio spread, which is an ideal option when the prices do not move much. Using the bull ratio spread strategy, traders can earn profits when the prices of underlying securities increase slightly.