Ratio Spreads

Mechanics, Motivation & Managing

Jim Bittman
Senior Instructor
The Options Institute at CBOE
Disclaimer

In order to simplify the computations, commissions have not

been included in the examples used in these materials. Commission
costs will impact the outcome of all stock and options transactions
and must be considered prior to entering into any transactions.
Any strategies discussed, including examples using actual
securities and price data, are strictly for illustrative and educational
purposes only and are not to be construed as an endorsement,
recommendation, or solicitation to buy or sell securities.
Options involve risks and are not suitable for everyone. Prior to
buying or selling an option, an investor must receive a copy of
Characteristics and Risks of Standardized Options. Copies may be
obtained from your broker or from The Chicago Board Options
Exchange, 400 S. LaSalle, Chicago, IL 60605. Investors
considering options should consult their tax advisor as to how taxes
may affect the outcome of contemplated options transactions.

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Session Outline

Ratio Spreads – How They Work

Why Use Ratio Spreads?
Price Behavior
Managing Ratio Spreads
A Judgment-Based Approach

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Ratio Spread Defined

The term “ratio spread” is loosely used to

describe any multiple-part option position in
which there are an unequal number of long
and short options at different strikes
Typically, the term “ratio spread” implies that
there are more short options than long
options, and the term “volatility spread” (or
“back spread”) implies more long options
than short.
Note: multiple commissions are involved
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1×2 Ratio Spread with Calls

+1 35-day 105 Call 2.99 (2.99)

−2 35-day 110 Call 1.67 ea. 3.34
Net credit: 0.35

Underlying price = 100

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The Ratio Spread with Calls at Exp

0
100 105 110 115 120

-5

Current
-10
Market

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1×2 Ratio Spread with Puts

+1 35-day 95 Put 2.70 (2.70)

−2 35-day 90 Put 1.55 ea. 3.10
Net credit: 0.40

Underlying price = 100

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The Ratio Spread with Puts at Exp

0
80 85 90 95 100

-5

Current
-10
Market

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Ratio Spreads – the Motivation

+1 35-day 105 Call 2.99 (2.99)

−2 35-day 110 Call 1.67 ea. 3.34
Net credit: 0.35
Margin requirement: $2,200
?
Annualized return if all
options expire worthless ≈16%
?
Margin = 20%
Return of short× strike
= cr/marg days per / days to exp
= .20 × 365/35
× 110 × $100
= 35/2,200 = 0.16 = 16%
= $2,200
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Ratio Spreads and Time

Value (Negative = Credit Received)

0.60
exit
0.30
0.00
-0.30
-0.60 enter
-0.90
-1.20
-1.50
50 40 30 20 10 0
Days to Expiration

Underlying, 100; volatility, 40%; int rate, 1.20%; no div.

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Ratio Spds & Time – Observations

The value of a ratio spread changes from a

credit prior to 35 days before expiration to a
debit at 10 days and then to zero.
The lower the volatility, the sooner (more time
to expiration) the value becomes a debit.
Goal: establish for a credit prior to 35 days &
close for another credit at two weeks to 10
days prior to expiration.
To “make money” requires time.
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Ratio Spread and Volatility

Value (Negative = Credit Received)

0.60
0.30
0.00
-0.30
-0.60
-0.90
-1.20
-1.50
10 15 20 25 30 35 40 45
Volatility %

Underlying, 100; volatility, 40%; int rate, 1.20%; no div.

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Ratio Spds & Vol. – Observations

The higher the implied volatility, the larger the

credit received for establishing a ratio spread.
At “low” levels of volatility, ratio spreads are
established for a net debit.
Ratio spreads work best when volatility is
declining.

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 Ratio Spreads
Managing Positions
Ratio Spds – Managing Alternatives

Close the position.

Buy back (cover) one of the short options;
create one vertical spread.
Buy one more of the long options; create two
vertical spreads.
Roll the two short options to a further-away
strike; extend the range of profitability and the
break-even point.

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Ratio Spds – Close the Position

Closing a ratio spread may result in a profit or a

loss, depending the underlying price, the time
to expiration and the level of implied volatility.
A position should be closed when:
– the profit target is achieved.
– the pre-determined maximum loss is reached.
– the market outlook is extremely uncertain and
increasing losses are feared.

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Ratio Spds – Managing Alternatives

Buy back (cover) one of the short options;

create one vertical spread.

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Ratio Spd: Buy One Short Option

Stock 100 Orig. position:

Days 35 +1 105 Call 2.99 Net Credit
−2 110 Call 1.67 ea. 0.35

Stock 112 Action:

Days 10 +1 110 Call 4.06 Debit (4.06)

New Position: +1 105 Call Net Debit

−1 110 Call (3.71)
< 105 max risk = (3.71) > 110 max profit = +1.29
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Ratio Spread → Vertical Spread

5
Orig. position

+1.29
0
100 105 110 115 120
(3.71)
-5 New position

Adjusting
-10
Point

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Ratio Spds – Managing Alternatives

Buy one more of the long options; create two

vertical spreads.

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Ratio Spd: Buy One More Long Opt.

Stock 100 Orig. position:

Days 35 +1 105 Call 2.99 Net Credit
−2 110 Call 1.67 ea. 0.35

Stock 112 Action:

Days 10 +1 105 Call 7.65 Debit (7.65)

New Position: +2 105 Call Net Debit

−2 110 Call (7.30)
< 105 max risk = (7.30) > 110 max profit = +2.70
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Ratio Spread → 2 Vertical Spreads

5
Orig. position

+2.70
0
100 105 110 115 120

-5

(7.30)
New position Adjusting
-10
Point

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Ratio Spds – Managing Alternatives

Roll the two short options to a further-away

strike; extend the range of profitability and the
break-even point.

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Ratio Spd: Roll Short Options

Stock 100 Orig. position:

Days 35 +1 105 Call 2.99 Net Credit
−2 110 Call 1.67 ea. 0.35

Stock 112 Action:

Days 10 +2 110 Call 4.06 ea. Net Debit
−2 115 Call 1.75 ea. (4.62) tot

New Position: +1 105 Call Net Debit

−2 115 Call (4.27) tot

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Ratio Spread → New Ratio Spread

Orig. position
5

0
100 105 110 115 120 125

(4.27)-5
New position

Adjusting
-10
Point

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Ratio Spreads & Volatility
Converting the 1-Year Std. Dev.

Index Level 100.00

Days to Exp 35
Implied Volatility 40%
Stock Price × I.V. × √ Days to Exp
√ Days per year
100.00 × .40 × √ 35
= 12.40
√ 365

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Ratio Spreads – Price Relationships

Volatility 30% 40% 50%

1 Std Dev 9.30 12.40 15.50
100 Call 3.76 4.99 6.22
105 Call 1.84 2.99 4.18
110 Call 0.79 1.67 2.70
115 Call 0.30 0.88 1.68
Long strike
Long 5%
strike
Long
out:
5%debit
strike
out:0.26
credit
10% out:
0.35credit 0.66
Short ≈strike
Short strike Std<Dev
1 Short1strike ≈ 1 Std Dev
Std Dev
Underlying Price: 100; Days to Exp.: 35
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Spread Greeks
30% Value Ì g v t
+1 105 C 1.84 +.32 +.039 +.11 −.35
−2 110 C 0.79 −.17 −.027 −.08 +.23
( .26) −.02 −.015 −.05 +.11
40%
+1 105 C 2.99 +.37 +.031 +.12 −.50
−2 110 C 1.67 −.24 −.025 −.10 +.40
.35 −.09 −.019 −.08 +.30
50%
+1 110 C 2.70 +.30 +.022 +.11 −.56
−2 115 C 1.68 −.21 −.018 −.09 +.45
.66 −.11 −.014 −.07 +.34
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 Real World Prices & Issues
Creating Ratio Spreads in Today’s Market
XYZ @ 96.15 (40 days to exp.)
XYZ

Ratio spread with puts? Stock stays above 75? 31

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Ratio Spread – Example

XYZ @ 96.16 40 days to expiration

Bid Ask I.V. +1 80 Put
90 Put 5.20 − 5.40 64% @ 2.50
85 Put 3.60 − 3.70 66% -2 75 Puts
80 Put 2.40 − 2.50 69% @ 1.60 ea.
75 Put 1.55 − 1.65 71% Net 0.70 Cr
1.60

1 Std Dev = 96.15 × .66 × √40 ≈ 21

√ 365
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Ratio Spread – Example

+1 40-day 80 Put 2.50 (2.50)

−2 40-day 75 Put 1.60 ea. 3.70
Net: 0.70 Credit
Margin requirement: $1,920
?
Annualized return if all
options expire worthless ?≈ 33%
Margin = 20%
Return of stock× price
= cr/marg days per / days to exp
= .20 × 365/40
× 96 × $100
= 70/1,920 = 0.33 = 33%
= $1,920
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Analyzing the Spread

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Ratio Spd – Values over Time & Price

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Ratio Spread – Example

XYZ @ 88.00 36 days to expiration

Was:
I.V.
0.70 Cr
90 Put 9.32 75% (was 5.30)
85 Put 6.97 78% (was 3.65) Now:
80 Put 5.05 81% (was 2.50) +1
75 Put 3.54 84% (was 1.60) −2
70 Put 2.24 85% (was 0.85) 2.00 Cr
Stock down 8.00 in 4 days

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Buy 1 80 Put (create 2 put spds)

Stock 88 at 36 days
+1 80 P (2.50) +1 80 P (5.05) +2 80 P (3.78) ea
−2 75 P 1.60 ea −2 75 P 1.60 ea
Net Cr 0.70 = Net Dr (2.18) ea
(5.05) Net Dr (4.36) tot

B-E = 80.00 – 2.18 = 77.82

Max Profit = (5.00 – 2.18) x 2 = 5.64
Max Risk = (2.18) x 2 = (4.36)

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Buy 1 75 Put (create 1 put spd)

Stock 88 at 36 days
+1 80 P (2.50) +1 80 P (2.50)
−2 75 P 1.60 ea +1 75 P (3.55) −1 75 P (0.35)
Net Cr 0.70 (3.55) = Net Dr (2.85)

B-E = 80.00 – 2.85 = 77.15

Max Profit = 5.00 – 2.85 = 2.15
Max Risk = (2.85)

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Roll 75 Puts to 70 Strike

Stock 88 at 36 days
+1 80 P (2.50) +1 80 P (2.50)
−2 75 P 1.60 ea +2 75 P (3.55)
−2 70 P 2.25 −2 70 P (0.30) ea
Net Cr 0.70 Net Dr (2.60) = Net Dr (1.90) tot

B-E = 80.00 – 1.90 = 78.10 & 60.00 + 1.90 = 61.90

Max Profit = 8.10 (@ 70.00)
Max Risk = Long Stock @ 61.90
Net investment now = 1.90 & 80 Put = 5.05
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Conclusions – Ratio Spreads

• In “high-volatility” markets, ratio spreads are

an alternative to covered calls and short puts
• Nearly zero delta, gamma, vega, theta
• Plan short strike to be at or beyond one
standard deviation (calculated from imp. vol.)
• 3 managing alternatives – plus variations
• Determine your adjusting points in advance
• “Whipsaw” price action is always bad!
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Ratio Spreads

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