Options are great! A trader can trade long, short, or even sideways with options! There are many different strategies, including the ratio spread. Options may seem complex to new options traders. But our options classes will help you move beyond the complicated. You will be able to understand options and how to trade them.
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Options Trading Rundown
To understand a rato spread, you need to understand the basics of the options. A call option is a contract that allows traders to profit if the stock goes up (if you buy that call). Or profit if the stock goes sideways (if you sell that call).
A put option is a contract that gives traders a chance to profit if the stock goes down (if you buy that put). Or profit if the stock goes sideways (if you sell that put).
Options traders who do not use margin accounts buy options only. They focus on making a profit if the stock moves in their direction within the option’s life.
Still, traders who have a margin account can trade spreads. Options selling is popular because a trader can buy one option and sell another against it – like collateral.
Some popular trades are vertical spreads, Iron Condors, Calendars, and butterflies. These options trades are “equally balanced” in the number of long and short contracts.
Butterflies use four contracts, two long and two short. Iron Condors use four contracts, two long and two short. Vertical spreads use one long contract and one short. Calendars also use two contracts, one long and one short.
The general reason for the “balanced” option trade is that no additional margin is required to “cover” a short option. Why? Because the long option “covers” the short option.
Ratio Spreads Explained
You get the idea. The ratio is “one for one” or “two for two” … always equal. But – what if we change that ratio? Say hello to the Ratio Spread!
What is a Ratio Spread? A ratio spread is where the trader uses multiple contracts (like a butterfly or a calendar), but the ratio is unequal. That ratio could be a “sell one – buy two” or “sell two, buy one.”
A ratio spread also uses two different strikes, all done within the same expiration period and on the same side.
We would use all calls or all puts, pick an expiration date, and do the trade within that expiration date, unlike a calendar where we would have different dates and the same strike.
Building a Ratio Spread
A ratio spread generally has a goal in mind – such as trading a vertical spread and adding a short contract to help pay for the vertical spread. You could also sell an option against our stock (a covered call, for example) with an added call credit spread.
Five combinations are popular regarding ratio spreads: Long Ratio Call Spread, Short Ratio Call Spread, Long Ratio Put Spread, Short Ratio Put Spread, and the “Covered Ratio Spread.”
As you can see – these five spreads cover the call side (long and short), the put side (long and short), and the “covered” side.
In a “long call” ratio – the outcome would be a call credit vertical spread (a bear call spread) with an additional long call.
In a “short call” ratio, the outcome would be a call debit vertical spread (a bull call spread) with an additional short call.
Same expiration and same side – only calls and only using the SEP 20 expiration. Below, we have the put side – first, the long put ratio (green) and then the short put ratio (red).
Understanding Options Lingo
In the trading world, options talk can get confusing. First, the option’s name usually gives us clues about the type of trade. A “long trade” is the side where we end up in a trade that was purchased “net long” (a trade with one contract short and two contracts long is “net long”).
A”short trade” is the side where we sell the trade to open (a trade with one contract long and two contracts short is “net short”). That has confused new traders to this day!
In options trading – when the trader says they’re getting a “long put,” it doesn’t mean they are bullish on the market with a put. It means they’re “net long” (they “bought”) a put. Buying a put is a bearish trade strategy.
So with a ratio spread – a “long call ratio” means we have an unbalanced trade (1 contract long or short … and two contracts the other way). To know which side was “two,” we look at the name.
Options trades used to be over the phone. We couldn’t trade them on a computer in the old days! So, a phone call to the broker would sound like this:
“Bob, I want to enter into $SPY OCT 20, 2024 expiration with a 535 / 536 long call ratio.” The broker would immediately understand that the trade was “short the 535 and buy two 536 call contracts.”
How does the broker know this? We use a call credit spread to finance a single long call. In other words, we bought long calls twice. We bought the short call once, but the long calls were the 535. Then we would have a bull call spread + a long call, which would be debit for the call and debit for the bull call spread.
Understanding Different Spreads
A “Vertical” spread trades all calls or puts. But the strikes are picked vertically within a single expiration. The name comes from the move in the strike choices. (see the picture below)
“Calendar Spreads” are called that because the trade uses different expiry (moving dates) but not moving strikes. The name comes from the move within the options expiration. (See the picture below)
In the picture above – we have the SEPT 20 and the SEPT 27 expiry but the same strike (530 calls). A “diagonal” spread changes date and strikes but stays on the same side (calls only or puts only). The name comes from the move within the options dates.
The picture above shows a diagonal trade – where we would still have the same ratio (1 long and 1 short). The common approach in the options trading world is always to have an equal number of long and short contracts (which is why none of these other options mention the number of contracts used in their name).
As soon as we begin attempting to build spreads with unequal contracts, the name “ratio” shows up.
Neat, right? Not so complicated after all. Long options trades imply what we did (bought the options or sold the options), and the word “ratio” shows up if there are more short options than long options (or longer than short options).
You’ll also hear of “ratio flies” (a butterfly with an added vertical spread) and condors with wings, which are iron condors with an added vertical spread (which changes the ratio).
Long Call Ratio Spread
With a long call ratio spread, we want to build the spread higher than the current stock price. In other words, we are using ATM and OTM options.
Generally, we will use a long call ratio spread if the trader believes there will be a sharp move higher in the stock market. Or a sharp move higher in the volatility (because the trade is a long call but paid for with a bear call spread).
A long call increases in value when volatility increases quickly, and it increases in value when the underlying stock moves up quickly. If both things happen, then the trade will profit very quickly!
The bear call spread has “capped gains,” but the single call option has unlimited upside gains. Below is a picture showing the typical risk graph of the long call ratio spread.
The trade has a “V” shape to it. That is because if the stock only moves up a little – it could threaten the bear call spread (make it possibly lose), and at the same time, the long call would lose because it was still OTM at expiration.
So, reserve this trade for potential “big move” plays where you are also worried there will not be a move. If there is no move at all – then the long call loses. But the loss is mostly covered by the short call spread (the bear call spread).
The trade has a max loss equal to the high strike minus the low strike (the width of the bear call spread) plus the debit you spent to open the trade (or minus the credit you collected to open the trade).
Huh?
Example
Suppose I sold a 90 / 100 bear call spread for 4.00$ credit and bought an additional 100 strike call for 3.00$. The ratio spread would open for 1.00$ credit. But if I opened a 90 / 100 bear call spread for 4.00$ credit and bought an additional 100 strike call for 4.50 debit, the trade would open for 0.50¢ debit.
The picture above shows a long call ratio spread where we sell one call (535 strike) and buy two calls (537 strike). The risk of loss is the width of the strikes (2.00) plus the debit paid (9.41) for a total risk of 11.41$ (not counting fees and commissions). (See picture below).
The breakeven in the trade is 548.41$. We can calculate as “upper strike + (width +debit)” and for our example that means 537 strike +9.41 = 548.91$
Short Call Ratio Spread
A short call ratio spread means two calls short versus one call long. The trade is a bull call spread with an added short call to help finance the trade.
While the long call ratio spread had a fixed total loss, this trade has unlimited losses, so be careful! The trade looks a lot like a butterfly – except there is no protection if the stock overshoots the “tent” and continues to rally higher.
The higher the stock climbs above the trade – the more loss the trader could take. As a result, this makes the trade dangerous to newer traders.
I never recommend that a trader do this unless they cover the short call with stock (or synthetic stock). If the trader does not have that short call covered – it’s best to trade a butterfly trade instead.
Example
This trade is volatile if the trader expects a slow grind in the underlying stock price or a slow decay in the volatility. The trader could see maximum profit if the stock grinds to the short strikes and stops. If the stock continues to rally past the short strikes, the trade begins to lose the credit and goes into the red once BE (breakeven) passes.
The picture above shows the 536 call is long and the 539 call is short. In other words, a bull call spread with a short call added. Since we’re selling two calls, we have a lot of credit – even after buying a long call.
We can calculate the BE in several ways. Under the lowest strike, all strikes lose. Above the lowest strike (535), the long call profits until we get to the short strikes. There could be maximum profit if the trade expired. But if the price increases and the short strikes go ITM, the trade begins to lose. The short calls begin to wipe the profit away from the long call.
If volatility rises, that rise will impact the two short calls more than the single long call. That volatility negatively impacts the trade. Considering the trade as two individual positions, it may be easier to calculate the profit.
The bull call spread can maximize profit if the short strike is ATM. And the long strike is completely ITM. Our example is a 4.00$ bull call spread so that the max profit would be 4.00$.
The short calls would see max profit at expiration OTM. If they’re ITM at expiration, they’ll be considered a loss. So this trade needs to be closed before it expires to avoid an “end of day rally” (EOD rally) that places the strikes ITM.
Short Ratio Put Spread
A Ratio Put Spread uses one long put near the money and two short puts farther OTM. The loss is like the short ratio call spread – in the idea that it has a large loss potential (the stock to zero). Like the other short ratio spread, I recommend using a put butterfly rather than a short put ratio spread.
As you can see in the risk graph above – the loss to the downside continues to zero and increases as the stock falls lower and lower, but in the risk graph of the butterfly (below), the loss caps on both sides.
Typically, this trade is built OTM on the put side – so the trader expects a fading stock price. We want a slow fade lower. There are no quick, sharp moves here that could increase the volatility, which isn’t good for the trade.
Max Profit comes with the high strike minus the low strike plus the credit collected. We could see max profit if the stock closed at the lower strike at expiration. The “Best” position would be to see price profit as if we were seeing a bear put spread make a profit.
Long Put Ratio Spread
The Long Put Ratio Spread has a short put closer to the money and two short puts farther OTM. As a result, this is a “bull put spread.” We use the credit collected to buy a long put. The trader would use this strategy to trade a sudden move lower in the markets with a reduced cost.
If volatility increases, it would generally be positive for this strategy. Therefore, this is a great combination since the volatility typically climbs when stocks fall fast.
Max Profit
Known as a long-put position, the farther the stock falls, the more profit this trade has (we would say “unlimited.” But the stock would stop falling at zero, so that is the cap on the profit). Once the loss of the put vertical is covered, any additional profit in the long put is considered a gain on the trade.
In the picture below, we have a 5.00 wide put credit spread and an additional long put; we need the market to move low enough to make the long put at 527 profitable enough to cover the loss on the bull put spread.
This trade needs to see a swift move in price. A slow grind will not help with the implied volatility. And the price likely would not fall far enough to cover the bull put spread.
Max Loss
For max loss – the stock price at expiration would be at the lower strike price. If that happened – the two long puts would be worthless with the short put ITM. We would calculate the loss as the difference between the strikes and debit. (5.00 widespread + 7.29 debit = 12.29 max loss).
Covered Ratio Spread
A Ratio Spread offers long and short opportunities at a discount (getting a cheaper call or put) and can be used to trade markets expected to move aggressively. There’s still one more Ratio Spread called a covered ratio spread.
A Covered ratio spread is a “covered” trade because the trader owns the underlying stock. This trade uses the call side. It’s another trade where the loss can be considerable because the stock could go to zero. We’d say “infinite loss,” but the stock would not go below zero for expiration.
In a Covered Ratio spread – the trader has 100 shares of stock for each “lot” of the ratio spread combo. So, there are 100 long shares for each two short calls and one long call “lot.” Generally, this trade reduces the “average share price” of the stock. Each time a trader closes a position in profit, the trader reduces the average share price. The example below makes more sense.
Example
Suppose I own 300 shares of AAPL, and I am willing to hold AAPL in a long-term account. I bought AAPL after its last breakout. But the stock has pulled back below my entry.
I don’t want to sell my AAPL position, and I am not overly concerned with the position in the long term, but it would be nice if I could lower my average breakeven (BE) of the stock.
I could use the Covered Ratio Spread to accomplish this.
Above is AAPL stock, and my average share price is $220, marked in a white line. At this point, the stock is still something I believe in, and I would like to reduce my average price per share slowly.
I could sell a 230 / 240 covered ratio spread; in this case, the short strikes are closer to the money, and the long call is farther OTM.
Profit
To calculate the net profit – we would take the lower strike price minus the stock purchase price + the credit received (230-220) + 4.40$ = 14.40$ profit. If the stock rallies to close above the short strikes at expiration, I would give up my stock – selling it at 230 a share.
If the stock at expiration is under the short strike, then I keep the credit in the trade at $4.40. I could subtract those premiums from the average stock price (220 – 4.40 = 215.60).
As a result, this would be my new average share price. I could again trade a covered ratio spread to get credit and lower my average share price. Over time – the lower average share price can go to zero.
To calculate the net profit – we would take the lower strike price minus the stock purchase price + the credit received (230-220) + 4.40$ = 14.40$ profit. If the stock rallies to close above the short strikes at expiration, I would give up my stock – selling it at 230 a share.
If the stock at expiration is under the short strike, then I keep the credit in the trade at $4.40. I could subtract those premiums from the average stock price (220 – 4.40 = 215.60).
As a result, this would be my new average share price. I could again trade a covered ratio spread to get credit and lower my average share price. Over time – the lower average share price can go to zero.
Final Thoughts: Ratio Spread
Please work through this article a few times to get comfortable with the background and paper trade strategy and get a feel for the type of move needed to see profit in these trades. Show the Breakeven (BE) on TOS by hitting the “confirm & Send” button. At this point, a dialog box displays the breakeven data.
You can review the information before taking the trade and sending it to the market. Hence the “confirm and send” button. It will likely show you a short call ratio spread as “illegal” simply because most new options traders will not have the required permissions to sell a naked call.
This was a complex article; if you have questions, you can ask them on Discord. We are always excited to help and to answer questions.
Frequently Asked Questions
A ratio spread is a high-probability trading strategy. It has the potential for big profits because of the spread.
It is a neutral to slightly bullish spread.
You calculate the spread by subtracting the bid from the ask.
