Ratio Spread

1. Definition

A Ratio Spread is an options strategy in which an investor holds an unequal number of long (buy) and short (sell) positions on the same underlying asset with the same expiration date. The most common ratio is 1:2, where the investor buys one option and sells two options at a different strike price.

2. Structure & Types

2.1. Call Ratio Spread

Used when the trader expects a moderate rise in the asset price. * Setup: Buy 1 Call (Lower Strike) + Sell 2 Calls (Higher Strike). * Mechanism: The premium received from selling two calls helps offset or completely cover the cost of buying the one call. * Max Profit: Achieved if the stock price closes exactly at the strike price of the sold calls at expiration. * Risk: Unlimited risk to the upside. If the stock price skyrockets, one short call is covered by the long call, but the second short call is naked, leading to uncapped losses.

2.2. Put Ratio Spread

Used when the trader expects a moderate decline in the asset price. * Setup: Buy 1 Put (Higher Strike) + Sell 2 Puts (Lower Strike). * Risk: Substantial risk if the stock price crashes significantly below the lower strike price.

3. Characteristics

3.1. Low to No Upfront Cost

Since more options are sold than bought, this strategy can often be established for a very low debit or even a Net Credit (receiving money upfront).

3.2. Theta Decay Benefit

With a net short position (more options sold), the strategy benefits from Time Decay (Theta). As time passes, the value of the sold options erodes faster, which is profitable for the trader if the price remains stable.

3.3. Volatility Risk

This is a neutral-to-directional strategy that profits from low volatility. If volatility spikes and the price moves sharply past the short strikes, the losses can be severe.