Spreads are highly effective means of trading. Vertical spreads, calendar spreads, diagonal spreads, butterfly spreads, condor spreads, etc., all have a unique purpose for particular market situations. Here, we will look at the construction and benefit of ratio spreads.

The most important thing to understand about ratio spreads is that, unlike standard spreads that offer you the opportunity to limit losses in exchange for a limited gain potential, ratio spreads sometimes involve significant risk; however, they can sometimes allow for significant gain potential. Ratio spreads involve the simultaneous purchase and sale of two different series of option contracts of the same type (puts or calls) on the same underlying security, but the quantity bought and sold are not the same.

It is critical to understand that while ratio spreads are obviously called “spreads,” the options are really only partially spread. Because the quantity is different for the number of options bought and sold, the excess on either side are either left long or uncovered (naked). This is critically important because while most spreads have a limited loss potential, any ratio spread that includes uncovered options will have an unlimited or significant loss potential.

Because a ratio spread is a type of vertical spread, the expiration month is typically the same for all options bought and sold. It’s the strike prices that will be different. Also because in-the-money options will typically result in an assignment or exercise, holding ratio spreads until expiration may cause you to temporarily establish a long or short stock position.

The resulting long or short position will need to be closed out in the market to fully realize the profit potential of the strategy.

TYPES OF SPREADS

The two main types of ratio spreads are 1x2 Ratio Spreads and 1x2 Ratio Backspreads. Both types of spreads involving call options are typically used when there’s a bullish bias, but call ratio backspreads are more bullish than call ratio spreads. Similarly, both types of spreads involving put options are typically used when you are bearish, but they too differ by your degree of bearishness. Put ratio backspreads are more bearish than put ratio spreads.

The basic structure of ratio spreads and ratio backspreads are as follows:

• Call Ratio Spread - Long 1 call at a lower strike, short 2 calls at a higher strike. Composed of 1 debit call spread and 1 naked call option.

• Put Ratio Spread - Long 1 put at a higher strike, short 2 puts at a lower strike. Composed of 1 debit put spread and 1 naked put option.

• Call Ratio Backspread - Short 1 call at a lower strike, long 2 calls at a higher strike. Composed of 1 credit call spread and 1 long call option.

• Put Ratio Backspread - Short 1 put at a higher strike, long 2 puts at a lower strike. Composed of 1 credit put spread and 1 long put option.

Because ratio spreads are made up of a debit spread and an additional uncovered (naked) option, you will be required to make a substantial margin deposit to cover the naked options that aren’t spread against the long options. “In the middle” (below) shows the profit/loss profile for ratio spreads. Because ratio backspreads are made up of a credit spread and an additional long option, your broker will require you to pay for the long option in full, meet an initial margin requirement and maintain funds in your account equal to the maximum loss amount for the spread. “Backing it in” (below) shows the profit/loss profile for ratio backspreads.

Although you may establish both types of these spreads by entering them as a single order, they will not typically be displayed as ratio spreads or ratio backspreads in your account. When viewing your positions, they will usually be paired up as simple two-legged spreads and unrelated long or naked options.

KNOWING YOUR PRICE

An important thing to learn about ratio spreads is how to specify a net debit or credit when entering an order. With a normal spread, you simply net the two prices together. With a ratio spread, it isn’t quite so simple.

The first step typically is to reduce the ratio spread to the smallest common fraction. Then you would figure out the market price (also called the natural) by multiplying the number of contracts by the price and then netting the two legs together.

Example (Call Ratio Spread):

• Buy 5 XYZ May 60 Calls @ 3

• Sell 10 XYZ May 65 Calls @ .75

5x10 reduces to 1x2

Then:

1 X -3 = -3.00

2 X + 0.75 = +1.50

Net natural = -1.50

The natural or market price is a 1.50 debit for each 1x2 spread. Because in this example we divided by 5 to reduce the ratio, there are five 1x2 spreads. So, to calculate the total cost of this trade, you would multiply the net price by the number of spreads multiplied by the options multiplier:

-1.50 X 5 X 100 = -$750.

CHARACTERISTICS

Ratio spreads, like other spreads, require you to decide what strike prices to use and how wide to make the spreads. Which strike prices you use, and whether or not those strike prices are in-, at- or out-of-the-money, will affect the magnitude of the underlying move needed to reach profitability and also determine whether or not the spread can be profitable if the underlying remains unchanged.

“Building your spread” (below) illustrates how to properly structure a ratio spread or ratio backspread to match your view of the market.

For example, if you are extremely bullish, you would want to use a call ratio backspread. However, a call ratio spread would be more appropriate if you are neutral to moderately bullish. Generally, the more bullish you are, the higher the strike prices you will use. It may even be possible to construct a call ratio spread to be profitable with no movement in the underlying stock if the long leg of the spread is in-the-money when the strategy is initiated.

Similarly, if you are extremely bearish, you would want to use a put ratio backspread, while a put ratio spread would be more appropriate if you are neutral to moderately bearish. Generally the more bearish you are, the lower the strike prices you will use.

Because they can often be entered at a much lower debit, ratio spreads may be an appealing alternative to regular debit spreads moderately bullish or bearish situations.

Though the risks can be substantially higher. Consider the following substitutions:

• A call ratio spread can be a lower cost substitute for an in-the-money or an at-the-money debit call spread. This strategy will have a naked margin requirement on the short options.

• A put ratio spread can be a lower cost substitute for an in-the-money or an at-the-money debit put spread. This strategy will have a naked margin requirement on the short options.

Ratio backspreads also can often be entered at a net credit. Therefore, ratio backspreads may be an appealing alternative to regular debit spreads in highly bullish or bearish situations. Though the risks can be higher, you may want to consider the following substitutions:

• A call ratio backspread can be a lower cost substitute for an out-of-the-money debit call spread. The additional long options can provide unlimited upside potential.

• A put ratio backspread can be a lower cost substitute for an out-of-the-money debit put spread. The additional long options can provide substantial downside potential.

WORD OF WARNING

As you can see on the profit and loss charts, because the objective is only moderately bullish or moderately bearish on ratio spreads, if the market overshoots the target, the position can result in a loss. The lower breakeven price on a call ratio spread is equal to the long strike price plus the initial debit. The upper breakeven price is equal to the short strike price plus the maximum gain. The lower breakeven price on a put ratio spread is equal to the short strike price minus the maximum gain. The upper breakeven price is equal to the long strike price minus the initial debit.

Conversely, even though ratio backspreads are extremely bullish or extremely bearish it may be possible to come out with a small profit if you are completely wrong and the underlying stock moves sharply in the wrong way. The lower breakeven price on a call ratio backspread is equal to the short strike price plus the initial credit. The upper breakeven price is equal to the long strike price plus the maximum loss. The lower breakeven price on a put ratio backspread is equal to the long strike price minus the maximum loss. The upper breakeven price is equal to the short strike price minus the initial credit.

The downside risk of call and put ratio spreads is equal to the initial debit. The maximum risk of call and put ratio backspreads is equal to the difference between the two strike prices minus the initial credit and occurs if the stock is at the long strike price at expiration.

While these examples deal exclusively with ratio spreads and ratio backspreads with a 1-to-2 ratio between the legs, it is possible to structure a ratio spread with a 1-to-3 ratio, a 2-to-3 ratio or other ratios. While the profit and loss charts will look similar to these, the important thing to realize is that the risk will go up substantially on a ratio spread with greater than a 1-to-2 ratio because the position will be naked a higher number of contracts. This increase in risk could result in higher profitability if the trade is profitable but a much greater loss if it is not. Similarly, if you lower the ratio, such as to a 2-to-3 ratio, risk will go down accordingly as will the potential profit.

With ratio backspreads, a higher ratio would result in a greater number of additional long options, which would effectively increase costs. This additional cost can create either greater profitability or greater loss depending upon whether the sentiment in the underlying security is ultimately correct or not.

Because ratio spreads and ratio backspreads involve some naked exposure, it is especially important to consider your risk tolerance before you establish your positions.

Randy Frederick is the director of derivatives for Charles Schwab & Co. Inc.