Ratio Spreads

When we are discussing Volatility spreads, it is not necessary for traders to have no view in the market. In Ratio Spreads, the trader benefits if there is a movement towards one direction. We have already discussed one such variation of Ratio Spreads namely Ratio Straddle!

Here, The term “Ratio” comes because the options trader is constructing the strategy with buying/selling unequal ratios of put options and call options, mostly to keep the net strategy delta neutral.

  • A ratio spread where more options are purchased than sold is sometimes referred to as back spread.
  • A ratio spread where more options are sold than purchased is sometimes referred to as front spread.

Under the assumption of Black Scholes Model, if we construct delta neutral ratio spreads, even when the options are purchased more than sold, will always result in a net credit.

Generally, the Ratio Spreads have all PEs or all CEs. If it has all PEs, it is referred to as Put Ratio Spread and if it has all CEs, it is referred to as Call Ratio Spread.

Call Ratio Front Spread

Call Ratio Front Spread is a neutral to bearish strategy with no upside risk. It is doing by selling a far OTM call option to Long Call Vertical Spread. It is also known as the 1CE2CE Strategy.

Setup:

  • Buy ATM/OTM Call Option – 1 Lot
  • Sell Far OTM Call Options – 2 Lots

Ideal IV Environment: High

Maximum Profit: Distance between the strikes + Credit received

How to Calculate Breakeven(s):

  • Upside: Short Call Strike + Maximum Profit Potential (Maximum Profit/Lot Size)
  • Downside: None

Example:

  • Short 32000CE at 70.5 – 2 Lot
  • Buy 31900CE at 110 – 1 Lot

ratio spread

Put Ratio Front Spread

Put Ratio Front Spread is a neutral to a bullish strategy with no upside risk. It is doing by selling a far OTM put option to Long Put Vertical Spread. It is also known as the 1PE2PE Strategy.

Setup:

  • Buy ATM/OTM Put Option – 1 Lot
  • Sell Far OTM Put Options – 2 Lots

Ideal IV Environment: High

Maximum Profit: Distance between the strikes + Credit received

How to Calculate Breakeven(s):

  • Upside: None
  • Downside: Short put strike – Maximum Profit Potential (Maximum Profit/Lot Size)

Example:

  • Short 31700PE at 42 – 2 Lot
  • Buy 31800PE at 71 – 1 Lot

Put Ratio Front Spread

  • NotesAlthough It sounds confusing, traders use different combinations of nomenclature. So, Front Ratio Call Spread or Call Ratio Front Spread means the same thing.
  • Call Ratio Front Spread behaves like a short straddle when it comes to the movement in payoff graphs when the impact of Theta is negligible like when DTE (Date to Expiry) is far.
  • Similarly, Call Ratio Back Spread behaves like a long straddle.
  • The highest profit happens when there is a movement towards the maximum profit zone near the expiry. But, if there is a significant movement when DTE is far i.e. Theta’s impact is negligible, a Call Ratio Front Spread will do almost similar damage like a short straddle. We will discuss that later with payoff graphs.

The points discussed above are also applicable to the Put Ratio Spreads.

In Short, the Ratio Spreads mimic Straddles but limits the risk or the reward in one direction.

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