A put ratio spread is a multi-leg, neutral strategy with undefined risk and limited profit potential. The strategy looks to take advantage of a drop in volatility, time decay, and little or no movement from the underlying asset.
Put ratio spreads have three components: one long put purchased in-the-money and two short puts sold at a lower strike price out-of-the-money. The short puts will have the same strike price. All three put options have the same expiration date. Put ratio spreads may be opened for a debit or a credit, depending on the pricing of the options contacts, but put ratio spreads are typically established for a credit. Ideally, the stock price closes at the short put strikes at expiration.
Put Ratio Spread market outlook
Put ratio spreads are market neutral to slightly bearish. The strategy depends on minimal movement from the underlying stock to be profitable. For the position to reach maximum profit potential, the underlying stock price would need to decline in price to close at the short strike prices at expiration. Therefore, a slightly bearish bias is an appropriate outlook for a put ratio spread.
If the put ratio spread is initiated for a credit, the profit potential is the amount of credit received plus the width of the spread between the long and short put options. However, if the underlying stock price increases above the long put option, a profit will still be realized. All options would expire worthless, and the initial credit received would remain. Put ratio spreads have undefined risk if the stock price experiences a significant move lower below the short puts.
A put ratio spread is used when the underlying asset is expected to stay within the range between the two strike prices before expiration.
How to set up a Put Ratio Spread
A put ratio spread is a bear put debit spread with an additional put sold at the same strike price as the short put in the spread. The bear put spread results in a risk-defined position with limited profit potential. The goal is for the stock price to close at the short strikes at expiration. This results in the short contracts expiring worthless, and the long put could be sold with the maximum intrinsic value.
If the underlying stock price rises above the long strike, all options expire worthless, and the maximum loss is limited to the debit paid or, if a credit was received at trade entry, the credit will be realized as a profit. However, because of the single naked put, if the stock price of the underlying asset falls below the short put options, the risk is unlimited until the stock reaches $0.
The debit paid or credit collected at entry will depend on how far in-the-money the long put option is and how far out-of-the-money the short put options are relative to the underlying’s stock price.
Put Ratio Spread payoff diagram
The put ratio spread payoff diagram illustrates the strategy’s different outcomes based on the underlying stock price. Ideally, the stock price closes at the short strike options at expiration. When a put ratio spread is entered, there is potential for either paying a debit or receiving a credit.
If a credit is received, the amount collected, plus the width of the strike prices, is the maximum potential profit for the position. If a debit is paid, the maximum potential profit is the width of the spread between the short and long strikes, minus the amount paid to enter the position
Maximum gain and loss are limited if the stock price exceeds the long put option. All contracts would expire worthless, and the premium paid or received at entry will remain for a profit or loss. Maximum loss is unlimited if the stock price exceeds the break-even point below the short puts.
For example, if a stock is trading at $48, a put ratio spread could be entered with one long put at $50 and two short puts at $45. Assume a $1.00 credit is received. If the stock closes at $45 the maximum profit potential is realized. $600 is the most that can be made on the trade (the width of the spread, $5, plus the $1.00 credit). The short puts will expire worthless, and the long put can be sold for $5, plus the initial $1.00 credit. If the stock closes at $39 on expiration, the short puts will cost $12 combined to exit, but the long put will be worth $11.
Because the position received $1.00 at trade entry, the position will break-even at expiration if the underlying stock is trading at $39. If the stock closes above $50, all options will expire worthless and the original credit of $100 will remain. If the stock closes below $39, the potential loss is unlimited until the stock reaches $0.
Entering a Put Ratio Spread
A put ratio spread is a bear put spread with a naked put option sold at the same strike price as the short put option in the spread. Put ratio spreads consist of buying-to-open (BTO) one in-the-money long put option and selling-to-open (STO) two out-of-the-money short put options below the current stock price. All options have the same expiration date.
The amount of contracts is variable, but the most common ratios are 2:1, 3:2, and 3:1. For example, if a stock is trading at $48, a put ratio spread could be entered with one long put at $50 and two short puts at $45.
Entering a put ratio spread may result in receiving a credit or paying a debit. The premium depends on multiple factors, including the width of the spread, how far in-the-money and out-of-the-money the options are, and implied volatility skew. For example, if the marketplace perceives an asset to be very bearish in the future, out-of-the-money options may be more expensive than normal, relative to the in-the-money option.
Exiting a Put Ratio Spread
A put ratio spread will experience its maximum profit potential if the stock price is exactly the same as the short strike options at expiration. In this scenario, or if the stock price closes above the short options and below the long option, the short put options expire worthless. The long put option that is in-the-money may be sold.
If the stock price closes above the long put option, all three options will expire worthless, and no further action will be needed. If the stock price closes below the short put options, all three options will be in-the-money and need to be closed if exercise and assignment are to be avoided.
Time decay impact on a Put Ratio Spread
Time decay, or theta, works in the advantage of the put ratio spread. Every day the time value of an options contract decreases, which will help to lower the value of the two short puts. Ideally, the underlying stock experiences minimal movement, and theta will exponentially lose value as the strategy approaches expiration. The decline in time value may allow the investor to purchase the short options contracts for less money than initially sold, while the in-the-money long option will retain its intrinsic value.
Implied volatility impact on a Put Ratio Spread
Put ratio spreads benefit from a decrease in the value of implied volatility. Lower implied volatility results in lower option premium prices. Ideally, when a put ratio spread is initiated, implied volatility is higher than where it will be at exit or expiration. Lower implied volatility will help to decrease the value of the two short puts more rapidly. Future volatility, or vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the pricing of the short options.
Adjusting a Put Ratio Spread
Put ratio spreads may be adjusted before expiration to extend the duration of the trade or alter the ratio in the spread. If the underlying security drops and challenges the short puts, buying additional long puts to reduce the put spread to a 1:1 ratio caps the position’s risk. Adjustments will most likely come with additional cost to the position, which will increase the risk, lower the profit potential, and narrow the break-even points. Furthermore, because put ratio spreads consist of two short contracts, assignment is a risk any time before expiration.
External factors may need to be considered when deciding to adjust or close a put ratio spread position. If an investor wants to avoid assignment risk, and/or needs to extend the trade into the future to allow the strategy more time to become profitable, the entire position can be closed and reopened at a future expiration date with the same, or new, strike prices. Typically, if the stock moves below break-even point, the position is closed instead of adjusted.
Rolling a Put Ratio Spread
Put ratio spreads require the underlying stock price to be at or near a specific price at expiration. If the position is not profitable and an investor wishes to extend the length of the trade, the put ratio spread may be closed and reopened for a future expiration date. Because more time equates to higher options prices, the rollout may cost money and add risk to the position, depending on the spread’s initial credit or debit.
If the stock price has moved below the short put options, there may be an opportunity to close out the existing position and enter a new spread with new strike prices closer to the underlying asset’s current price. However, doing so would not make sense if the new net debit paid exceeds the spread's width, as the position would no longer be profitable.
Hedging a Put Ratio Spread
The most common hedge for a put ratio spread is the purchase of additional long puts to reduce the spread ratio. Purchasing additional long put options converts the put ratio spread into a bull or bear put spread, depending on the security outlook at the time of the hedge. Protection from higher movement in the underlying stock is not necessary because the long put option has defined risk to the upside.
However, if an investor wants to protect against a significant decrease in the stock price, a long put option may be purchased below the short strikes. This would effectively create a bull put spread and protect against a decline in the underlying stock price. If the stock moves below the break-even point, the position may be closed instead of hedged.
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