A ratio spread is an options trading strategy that is used when a trader expects a low level of volatility in a security and their target strike price is unlikely to be exceeded by a significant degree. This expectation allows the trader to sell options with a different strike price to recoup a premium which offsets the cost of their primary options purchase.
Ratio Spread Example
Imagine that a trader expects a stock that is currently at $25 per share to exceed $30 per share at the end of the month. In addition, the trader does not expect that the stock price will go far beyond $30 per share.
Therefore, the trader can not only buy a call option for the stock with a strike price of $30, but they can also sell 2 call options with a $35 strike price whose recouped premiums exactly offset the premium paid for the $30 call.
This creates a cost neutral position with no downside risk (all options expire worthless at <$30), a small window of profitability (between $30 and $35) and an unlimited upside risk (above $35).
This risk profile makes sense to the trader because of their expectations of the upcoming price action of the stock over the next month.
Trading a Ratio Spread
There are a number of different methods for setting up a ratio spread trade, but the general strategy relies on an expectation of low volatility and a targeted strike price range. Generally traders using a ratio spread are looking to offset the low upside potential of their expectations by creating a low risk or no-risk entry point by selling offsetting options with a different strike price.
The substantial break-even area obtained in a ratio spread is the reward for accepting a hard cap to returns on the primary option position (the purchased options) and the unlimited upside risk on the secondary option position (the sold options).
Setting such a small band for success may seem like an extreme risk, but many securities display the kind of low volatility that makes ratio spreads an ideal trading strategy.
Traders generally do not employ a ratio spread because of a supreme predictive confidence of an exact outcome range, but rather as a result of historically low volatility and a hard structural limit on any possible upside moves in price as a result of relevant news or events.
The ratio spread strategy is an example of the advantages of having a broad toolkit of trading strategies when dealing in options and other derivatives.
While few traders would purposefully seek out ratio spread trades specifically, an experienced options trader would instantly recognize a prime opportunity to employ a ratio spread trade. Used in ideal circumstances, a ratio spread trade allows otherwise marginal trades to become favorable and already favorable trades to be optimized.
Ratio spreads and similar sophisticated options trading strategies allow experienced options traders to identify and execute highly favorable trades in circumstances that inexperienced traders would not even be aware of. That is why it is so important that day traders looking to trade in options arm themselves with the full toolkit of available trading strategies.