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Put Ratio Spread

ratio put spread

put ratio spread

the put ratio spread is a neutral strategy in options trading that involves buying a number of put options and selling more put options of the same underlying stock and expiration date  at a different strike price. it is a limited profit, unlimited risk options trading strategy that is taken when the options trader thinks that the underlying stock will experience little volatility in the near term.

put ratio spread construction
buy 1 in the money put
sell 2 out the money puts

a 2:1 put ratio spread can be implemented by buying a number of puts at a higher strike and selling twice the number of puts at a lower strike.

limited profit potential

maximum gain for the put ratio spread is limited and is made when the underlying stock price at expiration is at the strike price of the options sold. at this price, both the written puts expire worthless while the long put expires in the money. maximum profit is then equal to the intrinsic value of the long put plus or minus any credit or debit taken when putting on the spread.

the formula for calculating maximum profit is given below:

  • max profit = strike price of long put - strike price of short put + net premium received - commissions paid
  • max profit achieved when price of underlying = strike price of short put

    unlimited downside risk, little or no upside risk

    loss occurs when the underlying stock price experiences a sharp decline and drop below the breakeven point at expiration. there is no limit to the maximum possible loss when implementing the put ratio spread.

    any risk to the upside for the put ratio spread is limited to the debit taken to put on the spread (if any). there may even be a profit if a credit is received when putting on the spread.

    the formula for calculating loss is given below:

    • maximum loss = unlimited
    • loss occurs when price of underlying
    • loss = strike price of short - price of underlying - max profit + commissions paid

    breakeven point(s)

    there are 2 break-even points for the put ratio spread position. the breakeven points can be calculated using the following formulae.

    • upper breakeven point = strike price of long put +/- net premium received or paid
    • lower breakeven point = strike price of short puts - (points of maximum profit / number of uncovered puts)

    put-ratio-spread

    example

    suppose xyz stock is trading at $48 in june. an options trader executes a 2:1 ratio put spread strategy by buying a jul 50 put for $400 and selling two jul 45 puts for $200 each. the net debit/credit taken to enter the trade is zero.

    on expiration in july, if xyz stock is trading at $45, both the jul 45 puts expire worthless while the long jul 50 put expires in the money with $500 in intrinsic value. selling or exercising this long put will give the options trader his maximum profit of $500.

    if xyz stock price drops and is trading at $40 on expiration in july, all the options will expire in the money but because the trader has written more puts than he has purchased, he will need to buy back the written puts which have increased in value. each jul 45 put written is now worth $500. however, his long jul 50 put is worth $1000 and is just enough to offset the losses from the written puts. therefore, he achieves breakeven at $40.

    below $40, there will be no limit to the maximum possible loss. for example, at $30, each of the two written jul 45 puts will be worth $1500 while his single long jul 50 put is only worth $2000, resulting in a loss of $1000.

    however, there is no upside risk to this trade. if the stock price had rallied to $50 or higher at expiration, all the options involved will expire worthless. since the net debit to put on this trade is zero, there is no resulting loss.

    note: while we have covered the use of this strategy with reference to stock options, the put ratio spread is equally applicable using etf options, index options as well as options on futures.

    commissions

    for ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

    however, for active traders, commissions can eat up a sizable portion of their profits in the long run. if you trade options actively, it is wise to look for a low commissions broker. traders who trade large number of contracts in each trade should check out optionshouse.com as they offer a low fee of only $0.15 per contract (+$8.95 per trade).


    the put ratio spread is a neutral strategy in options trading that involves buying a number of put options and selling more put options of the same underlying stock and expiration date at a different strike price. it is a limited profit, unlimited risk options trading strategy that is taken when the options trader thinks that the underlying stock will experience little volatility in the near term.

    put ratio spread construction
    buy 1 itm put
    sell 2 otm puts

    a 2:1 put ratio spread can be implemented by buying a number of puts at a higher strike and selling twice the number of puts at a lower strike.

    limited profit potential

    maximum gain for the put ratio spread is limited and is made when the underlying stock price at expiration is at the strike price of the options sold. at this price, both the written puts expire worthless while the long put expires in the money. maximum profit is then equal to the intrinsic value of the long put plus or minus any credit or debit taken when putting on the spread. 

    the formula for calculating maximum profit is given below:

    • max profit = strike price of long put - strike price of short put + net premium received - commissions paid
    • max profit achieved when price of underlying = strike price of short put
    graph showing the expected profit or loss for the put ratio spread  option strategy in relation to the market price of the underlying  security on option expiration date.
    put ratio spread payoff diagram

    unlimited downside risk, little or no upside risk

    loss occurs when the underlying stock price experiences a sharp decline and drop below the breakeven point at expiration. there is no limit to the maximum possible loss when implementing the put ratio spread.

    any risk to the upside for the put ratio spread is limited to the debit taken to put on the spread (if any). there may even be a profit if a credit is received when putting on the spread.

    the formula for calculating loss is given below:

    • maximum loss = unlimited
    • loss occurs when price of underlying
    • loss = strike price of short - price of underlying - max profit + commissions paid

    breakeven point(s)

    there are 2 break-even points for the put ratio spread position. the breakeven points can be calculated using the following formulae.

    • upper breakeven point = strike price of long put +/- net premium received or paid
    • lower breakeven point = strike price of short puts - (points of maximum profit / number of uncovered puts)

    example

    suppose xyz stock is trading at $48 in june. an options trader executes a 2:1 ratio put spread strategy by buying a jul 50 put for $400 and selling two jul 45 puts for $200 each. the net debit/credit taken to enter the trade is zero.

    on expiration in july, if xyz stock is trading at $45, both the jul 45 puts expire worthless while the long jul 50 put expires in the money with $500 in intrinsic value. selling or exercising this long put will give the options trader his maximum profit of $500.

    if xyz stock price drops and is trading at $40 on expiration in july, all the options will expire in the money but because the trader has written more puts than he has purchased, he will need to buy back the written puts which have increased in value. each jul 45 put written is now worth $500. however, his long jul 50 put is worth $1000 and is just enough to offset the losses from the written puts. therefore, he achieves breakeven at $40.

    below $40, there will be no limit to the maximum possible loss. for example, at $30, each of the two written jul 45 puts will be worth $1500 while his single long jul 50 put is only worth $2000, resulting in a loss of $1000.

    however, there is no upside risk to this trade. if the stock price had rallied to $50 or higher at expiration, all the options involved will expire worthless. since the net debit to put on this trade is zero, there is no resulting loss.

    note: while we have covered the use of this strategy with reference to stock options, the put ratio spread is equally applicable using etf options, index options as well as options on futures.

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