This segment discusses and explains ratio spreads using puts or calls. Specifically, we explain under what conditions ratios are best placed and why.
A ratio spread is the purchase and sale of calls or puts in the same underlying and in the same expiration at different strikes and different amounts. It is usually done for a credit. The classic ratio spread is 1x2 and an example was shown using SPY of buying one 212 put and selling two 206 puts. Tom Sosnoff and Tony Battista use the Dough platform to show the setup of the trade.
When entering a ratio spread a trader should look for high IV and high IVR. The idea is to buy an ITM or ATM call (or put) and sell 2 farther out calls (or puts) for a total credit. The high IV and high IVR makes that possible
A call ratio spread has unlimited risk to the upside above the breakeven point. A put ratio spread has practically unlimited risk to the downside below the breakeven point. The maximum profit is the difference between the strikes plus the credit received but that is rarely achieved as the short strike would have to be pinned.
A table was displayed of a ratio spread versus a naked short position in FCX. Both scenarios showed the price received, breakeven price, margin used, probability of profit (POP) and max return on capital (ROC). It was used to explain some of the reasons for entering a ratio spread. Some of those reasons are the elimination of risk in one direction (eg. no downside risk in call ratio), a slight directional bias, a more distant break-even compared to a naked put or call and compared to a vertical a reduced cost basis.
There are some downsides to a ratio spread. It has unlimited risk in one direction and the chance that the max profit can be reached is low. It requires patience and the discipline of managing winners. The max profit is limited and the profit range is narrow (not counting on the range for keeping credit received). Volatile markets can be a problem.
The upsides, besides the risk only being to one side, is that the POP is higher and it is highly customizable. Different ratios can be used and calendar features can be included.
Watch this segment of Best Practices with Tom Sosnoff and Tony Battista for a discussion on how and why to use ratio spreads.
The traders in this segment are using features of Dough, our trading platform.
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