Execute A Put Ratio Spread – Anticipate Low Volatility

Introduction To Put Ratio Spread Option Strategy

Execute A Put Ratio Spread

The put ratio spread is a strategy that capitalises on the low volatility of the underlying security or asset. It involves buying in the money puts and selling out of the money puts in the ratio of 1 : 2. The put options involved are derived from the same underlying security, have the same expiration dates but have different strike prices. In terms of profit and loss, the put ratio spread has the potential for unlimited losses and limited profits due to the way it is structured as more puts are sold than bought. The put ratio spread could result in a debit or credit.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Low Volatility
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Unlimited losses
Step 7 : Loss calculation
Step 8 : Limited profit
Step 9 : Profit calculation of a put ratio spread
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade : Executing a put ratio spread
Step 12 : Exit Trade : Exiting a put ratio spread
Step 13 : Record Trade In Diary

 

Step 1 : Perform economic, fundamental and technical analysis

Economic analysis should be performed first. Perhaps, there are no major announcements or events in the markets that will cause volatility to increase over the life of the options used. Next, the options trader should perform fundamental analysis. In a scenario like this, option traders may look for an underlying security whose price will trade sideways. Perhaps the underlying security is already fairly valued by the markets and has no upside or downside. Next, use technical analysis to determine entry point. Look for a visual confirmation that the prices are stagnant, moving sideways or trading within very narrow ranges. Look out for chart patterns such as:

If a trader is confident, he may execute this trade within a rising channel with support and resistance. That is because in the event of rising prices, losses are capped.

Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis

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Step 2 :Outlook – Low Volatility

When a trader executes a put ratio spread, he does so in anticipation of low volatility of the underlying security over the near term. When the price of the underlying security does trade at the strike price of the written puts on expiration, the trader earns the maximum profit. This occurs because the written puts expire worthless and the long puts end up deeper in the money. This is of course the ideal scenario.

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Step 3 :Study the option chain

The trader should examine the option chain and select options for the construction of the put ratio spread.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

There are 2 breakeven price points, the upside breakeven point and the downside breakeven point. When the price of the underlying security breaks below the downside breakeven price point, the put ratio spread trades at a loss.

The downside breakeven point is:

Strike price of written put – ( price point where maximum profit is attained/ number of put options which are uncovered)

The upside breakeven point is:

Strike price of bought put + net credit

Apply this formula if a net credit is received.

OR

Strike price of bought put – net debit

Apply this formula if a net debit is paid to initiate the trade.

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Step 5: Understand Your Profit Zones

Execute A Put Ratio Spread

The price of the underlying security must trad within the breakeven points in order for the put ratio spread to be profitable.

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Step 6 : Unlimited losses

When there are a greater number of short options than long options in a spread, the trade can experience unlimited losses. This applies to the put ratio spread as the short to long puts are in the ratio of 2 : 1. Another point to note is that losses of the put ratio spread will start to mount after the price of the underlying security breaks below the breakeven point. The breakeven price point is the price point at which there is neither profit nor loss. Hence, as the price of the underlying security moves below the breakeven point, losses will start to increase.

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Step 7 : Loss calculation

The loss can be calculated as :

Strike price of written puts – price of underlying security – maximum profit attainable + commissions paid to the broker

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Step 8 : Limited profit

The profit potential of the put ratio spread is limited because of the way it is structured. That is, there are 2 written out of the money puts for every long in the money put.The short puts limits the profit realisable from the long put. The maximum profit occurs when the price of the underlying security is trading at the strike price of the written puts on expiration of the options. When that happens, the trader earns a maximum profit when the written puts expire worthless and the long put expires in the money.

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Step 9 : Profit calculation of a put ratio spread

The maximum profit can be calculated as :

Difference in the strike prices of the long and short puts + net credit received – commissions paid to the broker

To clarify that, you can also calculate the maximum profit as:

Higher strike price put – lower strike price put + net credit received – commissions paid to the broker

The above formulas can be used when a net credit is received. But when a net debit is paid to initiate the trade, the maximum profit can be calculated as:

Higher strike price put – lower strike price put – net debit paid – commissions paid to the broker

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Step 10 : Calculate Risk & Reward Ratio

At this stage, with the proper stop losses in place, an options trader is able to calculate an estimated risk reward ratio to determine the attractiveness of the put ratio spread. Compare this particular trade to other trades performed in the past. The  options trader must ask himself this question : Is the risk and reward ratio attractive enough? Consider this in the context of similar trades and the probability of a profitable trade.

Read more : Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Set Up Trade : Executing a put ratio spread

  • Buy 1 in the money put option (Higher strike price)
  • Write 2 out of the money put options ( Lower strike price)

The above is a put ratio spread, constructed with only put options. As long as the ratio of bought puts to written puts is 1: 2, it is a put ratio spread. Hence a trader can buy 5 ITM puts and write 10 OTM puts.

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Step 12 : Exit Trade : Exiting a put ratio spread

  1. If the price of the underlying security makes a falls below the maximum profit level before expiration, the trader may want to close the trade by buying back the short puts and selling the long put.
  2. If the price of the underlying security moves higher, the trader can choose to let the options expire, keeping the net credit if there is any.

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Step 13 : Record Trade In Diary

After the trade has been exited, the trade should be recorded in a trading diary for analysis, tracking and comparing with other trades performed before. The  options trader must compare this particular trade to other  trades done in the past and fine tune his trade process.

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Example Of A Put Ratio Spread

EEE Corp is currently trading at a price of $57.50. An options trader decides to execute a put ratio spread by :

  • Buy 1 in the money December 60 put @ $4.50
  • Write 2 out of the money December 55 put options @ $2.00 each

In this case, there is a net debit. This is not the case all the time. Sometimes, a net credit is received depending on the dynamics of option pricing.

In this case the net debit is :

$4.50 x 100 – $2.00 x 100 = $50

Hence, $50 was paid to create the put ratio spread.

If the price of EEE trades at $55 on expiration of the options, the written puts will expire worthless and the long put will have an intrinsic value of $500.

The maximum profit is thus:

$500 – $50 = $450

If the above is something you do not understand, then another way to calculate the maximum profit is:

Difference in strike prices – net debit (or + net credit)

Therefore the maximum profit can also be calculated at:

$5 x 100 – $50 = $450

An easier way to think about this is the gain on the long put is only $50 and since the written puts @ $2 each expired worthless, the profit attained is thus:

$200 x 2 + $50 = $450

If the price of EEE trades at $70, the loss of the put ratio trade’s loss is only $50, the net debit, because all the options become out of the money and expire worthless.

But if EEE trades at $35 on expiration, the losses on the written puts will be :

$2000 x 2 – $200 x 2 = $3600

The gain on the long put is:

$2500 – $450 = $2050

The realisable loss is thus :

$3600 – $2050 = $1550

As you can see the lower the price goes, the greater the mounted losses. As an options trader who executes a put ratio spread, the trader does not want to price of the underlying security to go below that of the downside breakeven price point.

Put ratio spread vs other similar strategies

The put ratio spread experiences a maximum profit at only 1 price point. Option strategies like the variable ratio write and short strangle have a range of prices at which maximum profit is attainable.

The short straddle is also quite similar to the put ratio spread but has upside risk while the put ratio spread does not have upside risk.

Put Ratio Spread vs Ratio Spread(Call Ratio Spread)

The put ratio spread is constructed with put options while the call ratio spread is constructed with call options. The call ratio spread is projecting a less bullish outlook and has upside risk compared to the put ratio spread.

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