Ratio Spreads

The term ratio implies that there is a weighted difference for the ratio spread strategy. This is usually a credit spread or an even cost spread, meaning traders receive money or pay no premium for entering this trade. For this illustration, I use abull call ratio spread. Traders would use this strategy if they were slightly bullish on the market, buying a close-to-the-money or

in-the-money call option, and then selling or writing two or more out-of-the-

money higher strike price call options. Generally, because of the exposure

from the upside risks, the common strategy is a one to two ratio, buying one

call and selling or writing two call options.

This is usually a strategy that gives you a little premium or credit, which

is one of the motivating factors for deciding to do this particular trade. It

uses the market’s money to help finance your trade or even pays you to

have a position in the market. If you think the price of a particular futures

contract may rise in a certain period of time but may not exceed a certain

level, then this is a good strategy to implement. If the market remains flat or

reverses lower at expiration, then the out-of-the-money call options will off

set the loss of the close-to-the-money or in-the-money calls and possibly

provide a profit after commission and fees.

Because this particular strategy involves writing or selling calls on a

ratio basis, one or more calls are usually uncovered, and a margin require-

ment or good-faith deposit would be required for this trade. Remember, be-

cause you have at least three positions in this strategy, there are three or

more separate commissions and related fees involved.

As with other spreads, you have the flexibility to leg in or out of one or

any combination of the call options. This is a practice known as

adjusting

your position. Anytime you adjust your position, you may be increasing or

reducing your risk. When your exposure to risk increases, usually so does

your margin requirement. The probabilities that an explosive upward price

change will not happen in the market are on your side. However, if an un-

expected event does occur, then this position will expose the trader to an

unlimited loss potential.

A

bear ratio put spread

would be the exact opposite of this trade. In

this strategy, you would buy a close-to-the-money or in-the-money put and

sell two or more further out-of-the-money puts. You would use this strategy

if you are slightly bearish on the market. Again, due to the exposure of the

downside risks, the common strategy is a 1-to-2 ratio where you buy one

put and sell or write two put options. Because this particular strategy in-

volves writing or selling puts on a ratio basis, one or more puts are usually

uncovered and a margin requirement or good-faith deposit would be required

for this trade.

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