Unlock Profit Potential with the Put Ratio Spread

This comprehensive course explores the Put Ratio Spread, an advanced options strategy ideal for traders with a mildly bullish, neutral, or mildly bearish outlook on a stock or index.

What is a Put Ratio Spread?

The Put Ratio Spread strategically combines Put Options to potentially profit in multiple scenarios:

High Probability, Defined Risk

With a typical success rate exceeding 80%, the Put Ratio Spread is a powerful tool. However, it's crucial to understand that losses can accumulate if the share price falls significantly. This makes it particularly attractive when implied volatility is high.

Course Highlights:

Through videos, PDFs, quizzes, and assignments, you'll gain practical experience and confidence. A demo account allows you to practice implementing the strategies learned.

Elevate your options trading with the versatile Put Ratio Spread!

A ratio put spread is made up entirely of put options on the same underlying stock (or index). It’s constructed by purchasing one or more puts with one strike price and selling (writing) more puts than purchased with a lower strike price but the same expiration month. The result is a position consisting of long higher-strike puts and short lower-strike puts at a ratio of long to short that’s less than 1:1 (1:2, 1:3, 2:3 etc.). It therefore includes naked (uncovered) short put contracts.

A ratio put spread may be established for a net debit, a net credit, or even money. This depends entirely on the prices of the options chosen, and the ratio of long contracts to short.

Look at the put option quotes on SPY below for the Jan 20th expiry (6 weeks from today), remember SPY is trading at $225.15.

To establish a ratio put spread with SPY options, we might buy 1 Jan 20th $211 put for $0.72, and at the same time sell 2 SPY Jan 20th $210 puts for $0.63. The result is us holding an SPY Jan 20th $211/$210 ratio put spread at a 1:2 ratio for a credit of $0.54 ($0.72 paid vs. 2 x $0.63 received) or $54 total.

The ratio put spread is a neutral to slightly bearish/bullish strategy. It’s Ideal Market Conditions and Outlook

This strategy shines when you anticipate low volatility in the underlying stock. For instance, in our SPY example, we expect the price to stabilize and close at or above our short put strike price of $210 by expiration.

Flexibility in Market Outlook

The Ratio Put Spread offers flexibility:

Why We Prefer Credit Spreads

Establishing this spread for a credit is often preferred because it allows for potential profit from both rising and falling share prices. A debit spread, on the other hand, primarily benefits from neutral to slightly bearish scenarios.

This versatility makes the Ratio Put Spread a valuable tool for navigating various market conditions.

Since we are neutral on SPY, we expect to profit from the premium received from writing the short put contracts which we believe will expire at-the-money and with no value.

The maximum profit for a ratio put spread is limited, and will occur if SPY closes exactly at the short $210 put strike price at expiration. Note, this is a highly improbable event to occur.

Under this circumstance, the long SPY $211 put will be worth its intrinsic value (the difference between the puts’ strike prices) and the short SPY $210 puts will expire at-the-money and worthless. The maximum profit amount may be calculated with the following formula:

The maximum profit for the SPY example would occur if the underlying stock (or index) closed exactly at the short put strike price of $210 at expiration. The long $211 put would have an intrinsic value of $1, and the short $210 puts would expire at-the-money and with no value.

Maximum profit = ($1.00 strike difference x 1 long put) + $0.54 (credit) = $1.54, or $154 total.

This is a major reason why the put ratio spread can be more effective than the short put strategy. Comparing the two strategies below and simply buying the stock of SPY at $225.15, you will see that the max profit potential of the put ratio spread is higher than the short put. The long stock has a better max profit profile as upside profit potential is not capped. But don’t make a judgment just yet, there are more comparisons to be done later.

Understanding the Risk: Potential for Significant Loss

It's crucial to be aware of the downside risk. Because you sell more $210 puts than you buy $211 puts, you have an uncovered position. This means if SPY falls significantly, your losses can be substantial.

Think of it like this:

The more uncovered puts you sell, the greater this potential loss becomes. While the upside potential is attractive, it's essential to carefully manage this downside risk to avoid significant losses.

When comparing the put ratio spread versus the short put and buy the stock at $215.15, the downside loss for all strategies is said to be unlimited. But assuming the number of uncovered puts is the same in both option strategies, there will be less risk for the put ratio spread as the break-even price will be lower. This will be illustrated later.

Margin Requirements: Understanding the Risks

When you sell (or "short") options, you're usually taking on an obligation. This means you might need to buy or sell the underlying stock at a certain price. To protect against potential losses, your broker will require you to set aside funds or securities as collateral – this is called margin.

How Margin Works

Important Considerations for Beginners

Margin trading can be risky, especially if you're not familiar with how it works. It's essential to understand the obligations involved and manage your risk carefully. If you have any doubts, consult with a financial professional.

Comparing the margin requirement on the SPY put ratio spread versus buying the SPY stock at $225.15 versus simply selling the $210 put you will notice that there is more risk in buying the stock versus the other two strategies:

When we establish the ratio put spread as a credit...it gives us two ways of profiting:

However, If the spread was initially established at a net debit, this debit amount paid would be the limited upside loss. If the spread was initially established for even money, there is no upside profit or loss.

Comparing the put ratio spread to the short put and long stock strategies, the short put strategy in our example would have a slight edge over the put ratio spread. See the matrix below:

The best way to try and estimate return on investments for short naked option strategies is to use a ‘return on margin’ calculation. It is not perfect as margin is not a fixed number but it is the best way to compare strategies.

Looking at our SPY example:

{$154 (Max Profit)/$3,055 (Margin)}*100

= 5.04%

The break-even price for a ratio put spread at expiration will occur on the downside of the short put strike price. It may be calculated in advance with the following formula:

Again, look at the charts above, you will notice that when a ratio put spread is established at a net debit that the profit opportunities are limited whereas there are more profit opportunities when established as a credit. Also, when established for a debit there are two break-even prices.

At expiration, the break-even price for the SPY Jan 20th $211/$210 put ratio spread would be a closing underlying price equal to $210 (lower strike price) – ($1.54 maximum profit divided by 1 uncovered put) = $208.46

$210 lower strike – ($1.54 maximum profit divided by 1 uncovered put)

= $208.46

When you buy a stock the only way you can profit is when the share price rises or when you get paid a dividend. Another major advantage of the put ratio spread strategy is the downside leeway it gives you. The share price of SPY could fall by a certain amount and we would still make a profit.

Remember in our SPY example. The share price of SPY was $225.15 when we placed the $211/$210 put ratio spread. The breakeven on the trade was $208.46. This means that the share price of SPY could fall $16.69 ($225.15-$208.46) before we make a loss at expiration. This is the equivalent of a 7.4% fall in the value of the SPY share price.

We call this the ‘downside leeway’.

Now let’s consider our chances of winning. Which is more likely, SPY to close above $208.46 or SPY to close above $225.15? Obviously, SPY has a much better chance of closing above $208.46.

Most online brokers will tell you the probability of profit on every option trade you place. The probability with the SPY example was 97%. Does this mean we are guaranteed to make profit? No, but it means that you have much better odds.

In fact, when you buy a share you only have a 50/50 chance of profit, the short put strategy also has high chances of profit at 95%, but the put ratio spread has the best chance of all.

Before expiration, an investor can take a profit or cut a loss by closing out the spread. This involves selling the long put(s) and buying the short put(s), and these closing trades may be executed simultaneously in one spread transaction. Profit or loss would simply be the net difference between the debit initially paid (or credit received) for the spread and the credit received (or debit paid) at its closing.

It is important for you to get into the habit of creating profit and loss tables. Here is an example of a P&L table for the SPY Jan 20th $211/$210 Put Ratio Spread. Remember for the spread:

A decrease in volatility generally has a positive effect on a ratio put spread; an increase in volatility generally has a negative effect.

Time decay generally has a positive effect on a ratio put spread because there are more short puts than long ones. This is especially the case if the underlying stock (or index) stabilizes around the short strike price as expected.

Looking at the SPY Jan 20th $211/$210 put ratio spread, we have two positions to consider.

This means that the time value of the SPY Jan 20th $211/$210 put ratio spread will erode by $0.024 per share or $2.40 total per day. Now theta is working to our advantage as the value of the put options continues to decay as time passes.

Delta is the rate of change in the value of an option for a $1 move in the underlying share price.

In our example with the SPY Jan 20th $211/$210 put ratio spread, we have two positions to think about.

We can also consider delta as the same as owning 8.9 shares of SPY. Think about it...if SPY rose by $1 and we owned 8.9 shares we would make a profit of $8.90. The exact same as the SPY put ratio spread.

A couple of things to know about delta:

Assignment on any Equity option or American-style index option can, by contract terms, occur at any time before expiration, although this generally occurs when the option is in-the-money.

For an equity put option, early assignment generally occurs when the short put is deep in-the-money, expiration is relatively near, and its premium has little or no time value. If a ratio put spread holder is assigned early on short puts, then he may exercise as many long puts and to sell shares purchased via the assignment obligation. If assigned on uncovered puts (i.e., more short puts than he is long) then he must purchase underlying shares.

If early assignment is received on covered short puts of a ratio put spread, the cash settlement procedure for index options will create a debit in the investor’s brokerage account equal to the cash settlement amount. This cash amount is determined at the end of the day the long put is exercised by its owner. After receiving assignment notification, usually the next business day, when the investor exercises an equal number of long puts the cash settlement amount credited to his account will be determined at the end of that day. There is a full day’s market risk if the long option is not sold during the trading day assignment is received.

If assigned on uncovered short puts (i.e., more short puts than he is long), the cash settlement procedure will create a debit in the investor’s brokerage account equal to the total cash settlement amount.

The action you take at expiry will depend on where the share price is trading at:

With every option strategy, there are pros and cons. However, this is one of our favorite strategies for trading indexes. We love the fact that you have two ways to profit when you place the trade as a credit. Sometimes people say that it is the same as placing a ‘short put’, but the risk profile changes when placed as a ratio put spread and it is less risky than being short a put.

The downside is that you are not taking in as much credit as you do with the short put. Novice investors or investors with small trading accounts should stick with the bull put spread strategy.

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