For example, a trader who is neutral to bullish the crude oil market wants to sell puts below the market. He elects to sell the December 55 crude oil put because although he is not sure where prices will be at expiration, he is confident that they still will be above $55 per barrel. The trader sells 3 December 55 crude oil puts for $950 each for a total premium of $2,850. He takes a portion of the premium and buys 1 December 60 put for $1,400. His credit is as follows: $2,850 – $1,400 = $1,450.
As long as crude does not tank below $60, all options expire worthless and the trade earns $1,450. If the crude market moves lower, but remains above $55, the profits could be higher.
For instance, suppose on option expiration day, December crude is trading at $58. The 55 puts would expire worthless ($2,850 profit). The 60 put would expire $2 in-the-money, and be worth $2,000. If the cost of purchasing this option ($1,400) is subtracted, it nets a profit of $600. Therefore, the net profit on the trade would be $3,450 ($2,850 + $600 = $3,450).
If the price is nowhere close to your strikes, you can sell the protective put as the options near expiration and recoup several hundred dollars while the remaining short safely expires worthless.
Risks on a ratio credit spread, like futures trading or naked option selling, can be unlimited once the underlying contract exceeds the short option strike. Although a ratio credit spread still can be profitable beyond the short option strike price, it generally is a good idea to exit the position after the strike price of the short options is reached. After this level is exceeded, profits can begin to deteriorate and losses can begin to accrue quickly.
James Cordier & Michael Gross are authors of “The Complete Guide to Option Selling” 2nd Edition (McGraw-Hill 2009). They are co-portfolio managers of OptionSellers.com, an investment firm that offers managed option selling portfolios.