Ratio Spread Explained — Step-by-Step Guide & Transcript

[00:00] Jim Stokoe for Calculated Risk. And don't forget, before we get started, the best ways you can help us are by liking the video or subscribing to the channel. Either one of those guys really helps us out a lot. So what is the most flexible strategy in all of options?

[00:13] It may seem like a difficult question to answer, but I think there's a pretty clear-cut winner. It's got to be the ratio spread. Because at the end of the day, if you've got like a put ratio spread, is it bullish?

[00:25] Maybe, but maybe not. If you've got a call ratio spread, is it bearish? Maybe, but maybe not. It's not so simple when you dig beneath the surface. So let's get into it and let's unpack the ratio spread.

[00:38] So what is a ratio spread? Well, generally speaking, this is your classic one-by-two strategy. You buy one and then you sell two. That's the plain vanilla. That's the cookie cutter. That's the Betty Cracker recipe that is a ratio spread.

[00:52] Now, you can adjust the ratio. You can alter the ratio. It could be a one-by-three. It could be a two-by-three. It could be a three-by-five. It could be a 5 by 12. It can be whatever you want it to be, but the standard operating procedure for a ratio spread is a 1 by 2 where you're buying 1 and then selling 2.

[01:10] And essentially, the way you want to set it up is pretty straightforward. By selling 2 relative to just buying 1 or even selling 3 relative to buying 2, you always want there to be an unbalanced nature between the longs and the shorts

[01:23] because you want to make sure that you are picking up a credit on order entry such that if the stock doesn't move in the direction that you want it to move, which again, that's open for debate, which we'll get into here in just a second,

[01:35] you can put yourself in a position where it can still be a profitable trade. Like you can still make money because you collect a credit on order entry Okay but are ratio spreads bullish or are they bearish Well let start with the put ratio spread

[01:49] If I've got a put ratio spread, I'm buying one put that's closer to the money, and then I'm selling two puts that are further out of the money. So is that a bullish strategy or a bearish strategy or maybe something different altogether?

[02:01] Well, when you put the strategy on, as we're going to see here in just a couple of minutes, It has bullish delta to begin with because you're in a situation where if the stock does rally, all the options will expire out of the money and you will keep the credit that you collect on equity.

[02:16] So a lot of people would classify a put ratio spread as being a bullish strategy. And I wouldn't necessarily say they're wrong, but it might be a little bit incomplete. Similarly, with a call ratio spread, it's the same thing.

[02:30] Same logic, you just flipped around onto the other side of the option chain now. So I'm buying a call that's closer to the after money strike, and then I'm selling two calls that are further up the chain that are further out of the money. Is this a bearish strategy?

[02:42] Well, my deltas on entry would suggest that it's a bearish strategy. But again, it's not so simple when you start thinking about, you know, the stock moving, potential profits, losses, credits collected on entry. It's just not so simple.

[02:54] So let's hop into KC Trade and let's take a look. Okay, so here I am in my KC Trade platform. I have Amazon pulled up. We'll use Amazon for the purposes of this example. Let's set up a put ratio spread and then a call ratio spread in Amazon.

[03:10] So Amazon, I'm sorry, the September cycle has 43 days to go. Let's say I'm doing a classic one by two. Again, there's a number of ways you can set this up. But just for illustrative purposes here today if I buy a 270 and I sell a couple of 265s look at what happens on order entry I bullish delta right I collecting the credit that I want and I have a super high probability

[03:36] And so this is all obviously good. Look at Amazon at 274. And so if Amazon rallies from here, then these options are all going to expire out of the money. And so I'm essentially going to keep the full credit that I collect,

[03:50] or of course I can manage it at some point earlier, maybe buy it back for $1, buy it back for $1.50, whatever. But when it comes to the stock going higher, it's pretty easy and clear to see why some people would classify this as a bullish strategy.

[04:06] However, look at the profit potential down below where the stock is. We can do all this right on the table screen, right on the option sheet. you actually have additional profit potential below where the stock is.

[04:20] And if you happen to, let's grab a different color just because we can, if you happen to pin the 265 short strike, that's where you could potentially make your maximum profit on the trade of the credit collected

[04:34] plus the width of the vertical set. And so this is what I mean when I say, is it bullish? Kind of, but it's not super simple because I can make money to the downside too,

[04:47] and I can even make more money to the downside. Okay, sticking with Amazon, let's set up the same trade but to the upside now. So now I buy a call, and then I sell a couple calls that are further out of the money,

[04:59] and you can tinker around the spread width and kind of adjust. There's so many things you can do with the ratio spread. Again flexibility is truly unmatched But look at how this trade begins Again the polar opposite of what we just saw I got credit collect down entry That what I expect I have a super high probability That what I expect But now I bearish delta with a call ratio spread Okay If the stock goes down

[05:22] then these two options are both going to expire worthless. They're both going to collapse down to zero and I would be in line to keep my full credit collected. Again, I might manage it early. I might manage to get some percentage.

[05:34] That's a different discussion for another time. But notice, again, I have profit potential to the upside, and if I were to pin my short strike, which in this case would be the 280 strike,

[05:46] to the upside, I am going to be in line to potentially make the maximum profit on my ratio spread. Now, to be fair and to be, you know, truthful, it's very difficult to hit maximum profit or anywhere near maximum profit on a strategy like a ratio spread.

[06:00] So understand, that's not typically a feasible outcome for the end of a racial spread, but I don't think it's as easy as just saying they put racial spreads bullish and they call racial spreads bearish.

[06:13] I think it's more complicated than that. I think it's more complex than that. And it really speaks to the versatility and flexibility that is unmasked with the racial spread. So racial spreads truly are second to none when it comes to the adaptability, the flexibility, and the versatility of the strategy.

[06:27] But that comes at a cost, right? for every guinea there's a gotcha I mean I've heard it before you've heard it before I still don't know who said it but if you guys can figure that out please let me know because I would love to know it's more complex it's more complicated

[06:40] there's more moving parts that you have to make sure that you understand so you have a full grasp of what you are indeed signing up for and I'll see you guys next time