Ratio Spread Explained

Ratio Spread

The ratio spread is a neutral strategy in options trading that involves buying a number of options and selling more options of the same underlying stock and expiration date at a different strike price. It is a limited profit, unlimited risk options trading strategy that is taken when the options trader thinks that the underlying stock will experience little volatility in the near term.

Call Ratio Spread

Using calls, a 2:1 call ratio spread can be implemented by buying a number of calls at a lower strike and selling twice the number of calls at a higher strike.

Limited Profit Potential

Maximum gain for the call ratio spread is limited and is made when the underlying stock price at expiration is at the strike price of the options sold. At this price, both the written calls expire worthless while the long call expires in the money.

The formula for calculating maximum profit is given below:

• Max Profit = Strike Price of Short Call – Strike Price of Long Call + Net Premium Received – Commissions Paid
• Max Profit Achieved When Price of Underlying = Strike Price of Short Calls

Unlimited Upside Risk

Loss occurs when the stock price makes a strong move to the upside beyond the upper beakeven point. There is no limit to the maximum possible loss when implementing the call ratio spread strategy.

The formula for calculating loss is given below:

• Maximum Loss = Unlimited
• Loss Occurs When Price of Underlying > Strike Price of Short Calls + ((Strike Price of Short Call – Strike Price of Long Call + Net Premium Received) / Number of Uncovered Calls)
• Loss = Price of Underlying – Strike Price of Short Calls – Max Profit + Commissions Paid

Little or No Downside Risk

Any risk to the downside for the call ratio spread is limited to the debit taken to put on the spread (if any). There may even be a profit if a credit is received when putting on the spread.

Breakeven Point(s)

There are 2 break-even points for the ratio spread position. The breakeven points can be calculated using the following formulae.

• Upper Breakeven Point = Strike Price of Short Calls + (Points of Maximum Profit / Number of Uncovered Calls)
• Lower Breakeven Point = Strike Price of Long Call +/- Net Premium Paid or Received

Using the graph shown earlier, since the maximum profit is $500, points of maximum profit is therefore equals to 5. Adding this to the higher strike of $45, we can calculate the breakeven point to be $50. (See example below)

Example

Suppose XYZ stock is trading at $43 in June. An options trader executes a 2:1 ratio call spread strategy by buying a JUL 40 call for $400 and selling two JUL 45 calls for $200 each. The net debit/credit taken to enter the trade is zero.

On expiration in July, if XYZ stock is trading at $45, both the JUL 45 calls expire worthless while the long JUL 40 call expires in the money with $500 in intrinsic value. Selling or exercising this long call will give the options trader his maximum profit of $500.

If XYZ stock rallies and is trading at $50 on expiration in July, all the options will expire in the money but because the trader has written more calls than he has bought, he will need to buy back the written calls which have increased in value. Each JUL 45 call written is now worth $500. However, his long JUL 40 call is worth $1000 and is just enough to offset the losses from the written calls. Therefore, he achieves breakeven at $50.

Beyond $50 though, there will be no limit to the loss possible. For example, at $60, each written JUL 45 call will be worth $1500 while his single long JUL 40 call is only worth $2000, resulting in a loss of $1000.

However, there is no downside risk to this trade. If the stock price had dropped to $40 or below at expiration, all the options involved will expire worthless. Since the net debit to put on this trade is zero, there is no resulting loss.

Note: While we have covered the use of this strategy with reference to stock options, the ratio spread is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the ratio spread in that they are also low volatility strategies that have limited profit potential and unlimited risk.

Call Ratio Spread Explained

What is Call Ratio Spread?

The Call Ratio Spread is a premium neutral strategy that involves buying options at lower strikes and selling higher number of options at higher strikes of the same underlying stock.

When to initiate the Call Ratio Spread

The Call Ratio Spread is used when an option trader thinks that the underlying asset will rise moderately in the near term only up to the sold strikes. This strategy is basically used to reduce the upfront costs of premium paid and in some cases upfront credit can also be received .

How to construct the Call Ratio Spread?

Buy 1 ITM/ATM Call

Sell 2 OTM Call

The Call Ratio Spread is implemented by buying one In-the – Money (ITM) or At-the-Money (ATM) call option and simultaneously selling two Out-the-Money (OTM) call options of the same underlying asset with the same expiry. Strike price can be customized as per the convenience of the trader.

Strategy

Call Ratio Spread

Market Outlook

Moderately bullish with less volatility

Upper Breakeven

Difference between long and short strikes + short call strikes +/- premium received or paid

Lower Breakeven

Strike price of long call +/- Net premium paid or received

Risk

Reward

Limited (when Underlying price = strike price of short call)

Margin required

Let’s try to understand with an Example:

NIFTY Current market Price

Buy ATM Call (Strike Price)

Premium Paid (per share)

Sell OTM Call (Strike Price)

Net Premium Paid/Received

Suppose Nifty is trading at Rs 9300 . If Mr. A believes that price will rise to Rs 9400 on expiry , then he enters Call Ratio Spread by buying one lot of 9300 call strike price at Rs 140 and simultaneously selling two lot of 9400 call strike price at Rs 70. The net premium paid/received to initiate this trade is zero. Maximum profit from the above example would be Rs 7500 (100*75). For this strategy to succeed the underlying asset has to expire at 9400. In this case short call option strikes will expire worthless and 9300 strike will have some intrinsic value in it. However, maximum loss would be unlimited if it breaches breakeven point on upside.

For the ease of understanding , we did not take in to account commission charges . Following is the payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry NIFTY closes at

Net Payoff from 9300 Call Bought (Rs)

Net Payoff from 9400 Call Sold (Rs) (2Lots)

Net Payoff (Rs)

The Payoff Graph:

Impact of Options Greeks:

Delta: If the net premium is received from the Call Ratio Spread, then the Delta would be negative, which means slight upside movement will result into loss and downside movement will result into profit.

If the net premium is paid then the Delta would be positive which means any downside movement will result into premium loss, whereas a big upside movement is required to incur loss.

Vega: The Call Ratio Spread has a negative Vega. An increase in implied volatility will have a negative impact .

Theta: With the passage of time, Theta will have a positive impact on the strategy because option premium will erode as the expiration dates draws nearer.

Gamma: The Call Ratio Spread has short Gamma position, which means any major upside movement will impact the profitability of the strategy.

How to manage risk?

The Call Ratio Spread is exposed to unlimited risk if underlying asset breaks higher breakeven; hence one should follow strict stop loss to limit loses.

Analysis of Call Ratio Spread:

The Call Ratio Spread is best to use when an investor is moderately bullish because investor will make maximum profit only when stock price expires at higher (sold) strike. Although investor profits will be limited if the price does not rise higher than expected sold strike .

Bid-Ask Spread

What is a Bid-Ask Spread?

A bid-ask spread is the amount by which the ask price exceeds the bid price for an asset in the market. The bid-ask spread is essentially the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept. An individual looking to sell will receive the bid price while one looking to buy will pay the ask price.

Bid-Ask Spread

Understanding Bid-Ask Spread

A securities price is the market’s perception of its value at any given point in time and is unique. To understand why there is a “bid” and an “ask,” one must factor in the two major players in any market transaction, namely the price taker (trader) and the market maker (counterparty).

Market makers, many of which may be employed by brokerages, offer to sell securities at a given price (the ask price) and will also bid to purchase securities at a given price (the bid price). When an investor initiates a trade they will accept one of these two prices depending on whether they wish to buy the security (ask price) or sell the security (bid price). The difference between these two, the spread, is the principal transaction cost of trading (outside commissions), and it is collected by the market maker through the natural flow or processing orders at the bid and ask prices. This is what financial brokerages mean when they state that their revenues are derived from traders “crossing the spread.”

The bid-ask spread can be considered a measure of the supply and demand for a particular asset. Because the bid can be said to represent demand and the ask to represent the supply for an asset, it would be true that when these two prices expand further apart the price action reflects a change in supply and demand.

The depth of the “bids” and the “asks” can have a significant impact on the bid-ask spread. The spread may widen significantly if fewer participants place limit orders to buy a security (thus generating fewer bid prices) or if fewer sellers place limit orders to sell.

Market makers and professional traders who recognize imminent risk in the markets may also widen the difference between the best bid and the best ask they are willing to offer at a given moment. If all market makers do this on a given security, then the quoted bid-ask spread will reflect a larger than usual size. Some high-frequency traders and market makers attempt to make money by exploiting changes in the bid-ask spread.

Key Takeaways

• The bid-ask spread is essentially the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept.
• The spread is the transaction cost. Price takers buy at the ask price and sell at the bid price but the market maker buys at the bid price and sells at the ask price.
• The bid represents demand and the ask represents supply for an asset.
• The bid-ask spread is the de facto measure of market liquidity.

The Bid-Ask Spread’s Relation to Liquidity

The size of the bid-ask spread from one asset to another differs mainly because of the difference in liquidity of each asset. The bid-ask spread is the de facto measure of market liquidity. Certain markets are more liquid than others and that should be reflected in their lower spreads. Essentially, transaction initiators (price takers) demand liquidity while counterparties (market makers) supply liquidity.

For example, currency is considered the most liquid asset in the world and the bid-ask spread in the currency market is one of the smallest (one-hundredth of a percent); in other words, the spread can be measured in fractions of pennies. On the other hand, less liquid assets, such as small-cap stocks, may have spreads that are equivalent to 1 to 2% of the asset’s lowest ask price.

Bid-ask spreads can also reflect the market maker’s perceived risk in offering a trade. For example, options or futures contracts may have bid-ask spreads that represent a much larger percentage of their price than a forex or equities trade. The width of the spread might be based not only on liquidity, but on how much the price could rapidly change.

Bid-Ask Spread Example

If the bid price for a stock is $19 and the ask price for the same stock is $20, then the bid-ask spread for the stock in question is $1. The bid-ask spread can also be stated in percentage terms; it is customarily calculated as a percentage of the lowest sell price or ask price. For the stock in the example above, the bid-ask spread in percentage terms would be calculated as $1 divided by $20 (the bid-ask spread divided by the lowest ask price) to yield a bid-ask spread of 5% ($1 / $20 x 100). This spread would close if a potential buyer offered to purchase the stock at a higher price or if a potential seller offered to sell the stock at a lower price.

Elements of the Bid-Ask Spread

Some of the key elements to the bid-ask spread include a highly liquid market for any security in order to ensure an ideal exit point to book a profit. Secondly, there should be some friction in the supply and demand for that security in order to create a spread. Traders should use a limit order rather than a market order; meaning the trader should decide the entry point so that they don’t miss the spread opportunity. There is a cost involved with the bid-ask spread, as two trades are being conducted simultaneously. Finally, bid-ask spread trades can be done in most kinds of securities— t he most popular being foreign exchange and commodities.