This course dives into the Put Ratio Spread, an advanced options strategy perfect for traders with a mildly bullish, neutral, or mildly bearish outlook.

What is a Put Ratio Spread?

This strategy combines put options to potentially profit in several scenarios:

High Probability, Defined Risk

With success rates often above 80%, the Put Ratio Spread is powerful. However, significant price drops can lead to losses, making it particularly attractive when implied volatility is high.

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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 put ratio spread is capped and occurs when the underlying asset (like SPY) closes exactly at the short put's strike price at expiration—a highly unlikely scenario.

In this ideal (but improbable) case, the long put would be worth its intrinsic value (the difference in strike prices), and the short puts would expire worthless.

The maximum profit is calculated as:

Maximum profit = (strike price difference x number of long puts) + net credit received (or minus net debit paid)

For example, with SPY at $225.15, a $211/$210 put ratio spread has a maximum profit potential of $1.54 per share (or $154 total) if SPY closes exactly at $210.

This higher (though unlikely) profit potential is a key reason the put ratio spread can be more effective than a simple short put. While buying SPY stock at $225.15 has unlimited profit potential on the upside, the put ratio spread's maximum profit, while capped, is still significant and often more likely to be achieved than the stock price continuing to rise indefinitely. However, we'll explore more comparisons between these strategies later.

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

Buying stock only profits when the price rises or dividends are paid. A major advantage of the put ratio spread is the "downside leeway." SPY, at $225.15, with our $211/$210 put ratio spread, has a breakeven point of $208.46. SPY can fall $16.69 (7.4%) before we lose money at expiration. This is our "downside leeway."

Which is more likely: SPY closing above $208.46, or above $225.15? Clearly, $208.46 is much more probable. Brokers typically show the probability of profit (in this case, 97%).

This doesn't guarantee a win, but significantly improves the odds. Buying shares is roughly a 50/50 proposition. While the short put also offers a high probability of profit (around 95%), the put ratio spread offers the best chance of the three.

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:

Like all options strategies, the put ratio spread has its pros and cons. However, it's a favorite for index trading. We like that it offers two ways to profit when opened for a credit. While similar to a short put, the put ratio spread's risk profile is different and less risky.

The trade-off is a smaller upfront credit compared to a short put. Newer traders or those with smaller accounts should stick with the bull put spread.

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