Definition
Ratio Spread is a trading strategy in options that involves buying a certain number of options and then selling a larger quantity of out-of-the-money options. The purpose of this strategy is to generate a net credit to the trader’s account; this credit is the maximum possible profit. However, it’s a strategy with unlimited risk due to the increased number of options sold.
Key Takeaways
- Ratio Spread refers to an options strategy that is created by having an unequal number of long and short option contracts.
- This strategy allows traders to minimize their risk in case of unfavorable price movements, but it also restricts their profit potential if the price moves in a favorable direction.
- It is often used when traders and investors hold a moderate view of the market, whether it be bullish, bearish, or neutral. The exact composition of the portfolio depends on this particular view.
Importance
Ratio Spread is a significant term in finance, primarily used in options trading.
This strategy involves buying a certain number of options and simultaneously selling more options of the same underlying instrument and expiration date, but at a different strike price.
The importance of a ratio spread lies in its ability to profit from a stock option’s price changes within a specific price range.
It allows traders to reduce risk through the buying of options, possibly for a credit, while still making a profit.
This flexibility aids in maximizing profit potential while limiting risk, which is paramount in a volatile investment environment.
Explanation
Ratio Spread is a strategic tool extensively used in options trading. Its purpose is especially prominent in situations where a trader anticipates a limited change in the price of the underlying asset. Simply put, it’s a method that allows investors to benefit from non-drastic changes in market prices.
Particularly, it offers the opportunity for traders to make profits if the price of the underlying security moves a significant amount in either direction. Despite its many advantages, it should be noted that this strategy also presents a high level of risk. The use of Ratio Spread works by initiating an unequal number of option contracts; basically, when the trader buys and sells different amounts of options.
This is usually done in a 2:1 ratio, but this can vary based on the investor’s preference. The strategy aims to reduce the initial cost of establishing the spread and can even result in a net credit (i.e., a profit from the initiation of the strategy), while still letting the investor benefit from certain price movements. Overall, Ratio Spread provides a way for traders to potentially turn a profit from the volatility of the market.
However, due caution must be exercised due to the high risk associated with it.
Examples of Ratio Spread
Hedging Investment Portfolio – An investor who has a large holding of a particular company’s stock may consider using a ratio spread. Suppose they own a significant number of Google shares. If they believe the price of Google will stagnate or fall in the foreseeable future, they could implement a put ratio spread to protect their holdings. This strategy involves buying one or more at-the-money put options and selling a larger number of out-the-money put options. This can limit their losses if the stock declines, while also potentially profiting if the stock’s price stays the same.
Anticipating Volatility – A trader could deploy a call ratio spread in anticipation of volatility in Microsoft stock following an upcoming product announcement. This involves buying a lower-strike call and selling two higher-strike calls. If the stock price significantly rises following the announcement, the trader can reap the benefits. But if the price falls or stagnates, the maximum risk is limited to the initial outlay for buying the calls.
Speculating on Commodities – An oil trader might initiate a ratio spread if they believe oil prices will increase moderately in the upcoming months. They could buy one in-the-money call option (which gives them the right to buy oil at a lower price) and sell two or more out-of-money call options (obligating them to sell oil at a higher price). If oil prices increase moderately, they can exercise their purchased option and load up on oil at a lower price, and then sell at higher prices through the sold options. But if prices skyrocket, they may face potential losses as they have to supply more oil at prices lower than the market price.
FAQ: Ratio Spread
What is Ratio Spread?
A ratio spread is an options strategy that investors use when they anticipate minimal movement in the price of the underlying asset. It involves buying and holding a certain number of options contracts while simultaneously selling more options contracts.
What are the types of Ratio Spreads?
There are two types of ratio spreads: Call Ratio Spread and Put Ratio Spread. A Call Ratio Spread is a neutral to bullish strategy, while a Put Ratio Spread is a neutral to bearish strategy.
What are the benefits of Ratio Spreads?
The ratio spread strategy offers limited profit potential if the asset experiences minor price movements, or even substantial movements in some cases. It can also provide limited profit if the price of the underlying asset doesn’t move at all. This makes it very versatile.
What are the risks associated with Ratio Spreads?
The risk in a ratio spread trade is high because it involves selling more options than are bought, which could potentially lead to unlimited losses. Investors should therefore exercise caution and use this strategy only if they are experienced in managing such risks.
How is the Ratio in Ratio Spreads determined?
The ratio in Ratio Spreads is determined by the number of long options contracts to short options contracts. For example, if an investor buys 1 options contract and sells 2, the ratio is 1:2.
Related Entrepreneurship Terms
- Options Trading
- Call Ratio Spread
- Put Ratio Spread
- Bullish Strategy
- Risk Management
Sources for More Information
- Investopedia: This website provides a wide range of information and resources related to finance and investing, including glossaries of financial terms, articles about finance, online financial education courses, and financial news updates.
- The Balance: This site specializes in personal finance advice but also covers a wide range of topics in the realm of finance. They have an extensive library of informational articles.
- Fidelity Investments: As a well-established investment brokerage company, they offer valuable insights on various financial terms and concepts, which are to the benefit of both novices and experienced investors.
- Charles Schwab: This is another well-established financial services company that provides a wide range of information on financial terms and concepts, including ratio spread.
