By selling an option at one strike price, traders are able to leverage that premium into more options at another strike price. Ratio Backspreads usually are used when an underlying has been stagnant but is beginning to show signs of increasing activity in one direction.
Call Ratio Backspread: Short call A, Long calls B
Normally entered when market is near B and shows signs of increasing activity and has greater probability to upside. Profit is limited on downside, but open-ended in rallying market, whereas maximum loss is realized if the market expires at B.
Put Ratio Backspread: Short put B, Long puts A
Normally entered when market is near A and shows signs of increasing activity with greater probability to downside. Profit is limited to the upside but is open-ended in collapsing market. Maximum loss (B – A – initial credit) is realized if market expires at A.