Ratio Spread Strategy

What is a Ratio Spread?

A ratio spread is an asymmetric options strategy where you trade an unequal number of options—typically buying one option and selling two or more options at a different strike. The classic setup: buy 1 ATM call, sell 2 OTM calls (or the put equivalent). This creates a position that profits from moderate directional moves but has risk if the move is too large.

The "ratio" refers to the unbalanced legs. Common ratios include 1:2 (buy 1, sell 2), 1:3, or even 2:3. The strategy typically enters for a credit or small debit, profits in a sweet spot range, but has unlimited risk if structured with naked short options.

Example Setup (Call Ratio Spread):
Stock at $100
- Buy 1 ATM $100 call for $6
- Sell 2 OTM $110 calls for $2 each (collect $4)
Net cost: $2 debit
Sweet spot: Stock finishes at $110 at expiration

When to Use Ratio Spreads

1. Sideways Market with Slight Directional Bias

You think the stock will drift moderately higher (or lower) but not explode. Ratio spreads profit from this exact scenario—moderate moves with contained volatility.

2. High Implied Volatility

When IV is elevated, the short options you sell command high premiums. This makes ratio spreads more attractive as you collect fat credits on your short legs.

3. Reduce Cost of Directional Trade

Instead of buying a naked call for $6, use a ratio spread for $2 or even a credit. This dramatically reduces capital requirement while maintaining directional exposure.

4. Advanced Volatility Play

Ratio spreads have complex Greeks. They can profit from both directional movement AND volatility contraction. Professional traders use them to express nuanced market views.

Types of Ratio Spreads

Call Ratio Spread (Bullish)

Setup: Buy 1 lower-strike call, sell 2+ higher-strike calls
Outlook: Moderately bullish
Max profit: At short call strike
Risk: Unlimited upside (naked short calls)

Put Ratio Spread (Bearish)

Setup: Buy 1 higher-strike put, sell 2+ lower-strike puts
Outlook: Moderately bearish
Max profit: At short put strike
Risk: Down to zero (naked short puts)

Credit Ratio Spread

Structured to collect net premium upfront. If stock stays between strikes or moves moderately, you keep the credit.

Debit Ratio Spread

Pay small net debit for the position. Requires stock to move toward short strike to profit, but cheaper than buying naked options.

Profit & Loss Analysis

Call Ratio Spread Example: Stock at $50
Buy 1 × $50 call for $4
Sell 2 × $55 calls for $1.50 each
Net cost: $1

Scenario 1: Stock at $45 (Down)

• All options expire worthless
• Loss: $1 (initial cost)

Scenario 2: Stock at $55 (Sweet Spot!)

• Long $50 call: Worth $5
• Short $55 calls: Expire worthless
• Profit: $5 - $1 cost = $4 profit (400% return)

Scenario 3: Stock at $60 (Moderate Win)

• Long $50 call: Worth $10
• Short $55 calls: Lose $5 each = -$10 total
• Net: $10 - $10 - $1 = -$1 loss

Scenario 4: Stock at $70 (Big Move = Loss)

• Long $50 call: Worth $20
• Short $55 calls: Lose $15 each = -$30 total
• Net: $20 - $30 - $1 = -$11 loss (and growing)

Breakeven Points:
- Lower BE: $51 (long call breaks even)
- Upper BE: $60 (gains on long call = losses on short calls)
- Profit zone: $51-$60 (9-point range)

The Risks of Ratio Spreads

Managing the Risk

1. Add a protective wing (convert to broken wing butterfly)
Buy 1 far OTM call to cap your upside risk. This eliminates unlimited risk while slightly reducing profit potential.

2. Close at upper breakeven
If stock approaches your upper breakeven point, close the entire position. Don't let it run into unlimited risk territory.

3. Size appropriately
Never put more than 2-5% of your portfolio in ratio spreads. The risk of large moves means position sizing is critical.

4. Use alerts
Set price alerts at your breakeven points. If stock hits upper breakeven, immediately close or adjust.

Managing Ratio Spreads

If Stock Approaches Sweet Spot

This is ideal! Your profit is maximized when stock finishes exactly at the short strike. Consider:

• Closing at 75-90% of max profit (don't be greedy)
• Holding until expiration if very confident
• Adjusting short strikes higher/lower if you think stock will overshoot

If Stock Moves Beyond Upper Breakeven

Danger zone! Close immediately or adjust:

• Option 1: Close entire position, take the loss
• Option 2: Buy back the short calls, convert to long call
• Option 3: Roll short calls up and out to collect more premium

If Stock Stays Below Long Strike

You're going to lose your initial debit. Not much to do except:

• Close early to save remaining time value
• Let it expire worthless if close to expiration
• Roll the entire spread forward if you still believe in the thesis

Key Takeaways