Ratio spreads are versatile options strategies that involve buying and selling options in unequal quantities. By selling more options than you buy, you can often enter a position for a credit or very low cost while maintaining significant profit potential. However, the extra short options create unique risks that every trader must understand. This comprehensive guide covers everything you need to know about ratio spreads.
What is a Ratio Spread?
A ratio spread is an options strategy where you buy options at one strike price and sell a larger number of options at a different strike price. The most common ratio is 1:2, meaning you buy one option and sell two. The unequal quantities distinguish ratio spreads from standard vertical spreads where you buy and sell equal amounts.
The key concept: You sell more options than you buy. The extra premium collected from the additional short options reduces your cost or generates a credit. The trade-off is that you have unlimited risk beyond your short strike in one direction.
Types of Ratio Spreads
Call Ratio Spread (Front Spread)
A call ratio spread is bullish but not too bullish. You profit from a moderate move higher.
- Buy 1 lower strike call (at-the-money or slightly in-the-money)
- Sell 2 higher strike calls (out-of-the-money)
- Best when you expect a modest rally to the short strike
Put Ratio Spread (Front Spread)
A put ratio spread is bearish but not too bearish. You profit from a moderate move lower.
- Buy 1 higher strike put (at-the-money or slightly in-the-money)
- Sell 2 lower strike puts (out-of-the-money)
- Best when you expect a modest decline to the short strike
Call Ratio Spread Example
Stock XYZ is trading at $100. You expect it to rise moderately to around $110.
- Buy 1x $100 call for $5.00
- Sell 2x $110 calls for $2.00 each = $4.00
- Net debit: $5.00 - $4.00 = $1.00 ($100 per spread)
You now have a 1x2 call ratio spread centered at $110.
Put Ratio Spread Example
Stock ABC is trading at $100. You expect it to fall modestly to around $90.
- Buy 1x $100 put for $5.00
- Sell 2x $90 puts for $2.00 each = $4.00
- Net debit: $5.00 - $4.00 = $1.00 ($100 per spread)
You now have a 1x2 put ratio spread centered at $90.
Profit and Loss Analysis
Call Ratio Spread P/L
Using the call ratio spread example above:
Maximum profit: Achieved when stock closes at $110 (short strike) at expiration
The $100 call is worth $10.00
Both $110 calls expire worthless
Profit: $10.00 - $1.00 cost = $9.00 ($900 per spread)
Downside (stock below $100): All calls expire worthless. Loss is limited to your $1.00 debit ($100).
Upside beyond short strike: This is where the risk lies. If the stock rockets past $110, you have one uncovered short call that creates unlimited loss potential.
Breakeven on upside: $110 + $9 max profit + $1 debit = $120
Above $120, you lose dollar-for-dollar with the stock
Put Ratio Spread P/L
Using the put ratio spread example:
Maximum profit: Stock closes at $90 (short strike)
The $100 put is worth $10.00
Both $90 puts expire worthless
Profit: $10.00 - $1.00 cost = $9.00 ($900)
Upside (stock above $100): All puts expire worthless. Loss limited to $1.00 debit.
Downside beyond short strike: If the stock crashes below $90, you have one uncovered short put. The stock can theoretically go to zero, creating massive losses.
Breakeven on downside: $90 - $9 max profit - $1 debit = $80
Below $80, losses accumulate rapidly
When to Use Ratio Spreads
Ratio spreads work best in specific conditions:
- Moderate directional view: You expect the stock to move toward your short strike, not beyond
- High implied volatility: Overpriced options let you collect more premium on the extra shorts
- Target price trading: You have a specific price target where you want the stock to settle
- Volatility crush plays: After events like earnings, IV often drops significantly
- Near support/resistance: Technical levels where moves often stall
The Critical Risk Factor
The biggest danger with ratio spreads is the unlimited risk from the extra short option. Many traders have been severely hurt by ratio spreads when the market moved far beyond their expectations.
Risk management rule: Always know your breakeven points and have a plan if the stock approaches them. Never let a ratio spread become a catastrophic loss. Consider converting to a backspread if the move exceeds expectations.
Converting a Ratio Spread
If the stock moves beyond your short strike, you have several options:
Option 1: Close the Position
Accept the loss and close everything. This is often the safest choice before losses grow.
Option 2: Buy the Extra Short
Purchase another option to convert to a standard vertical spread with defined risk. This removes the unlimited risk.
Option 3: Convert to Backspread
Buy more options at an even further out strike to flip the position into a backspread. Now you profit from continued movement.
Converting Example
Your call ratio spread is being challenged - stock is at $115 and rising:
- Original position: Buy 1x $100 call, Sell 2x $110 calls
- Stock moves to $115
- Buy 1x $110 call to close one short
- New position: Long $100/$110 call spread (defined risk)
You have capped your risk by removing the naked short call.
Ratio Spreads for Credit
Some traders specifically structure ratio spreads to collect a net credit. This removes any risk on the side opposite the short strikes.
Credit Ratio Spread Setup
Stock at $100, looking for a credit call ratio spread:
- Buy 1x $105 call for $2.00
- Sell 2x $110 calls for $1.25 each = $2.50
- Net credit: $0.50 ($50 per spread)
If the stock stays below $105, all calls expire worthless and you keep $50. Your maximum profit is still at $110, and your risk is above $115.50.
Common Ratios Used
While 1:2 is most common, traders use various ratios:
- 1:2 ratio: Most common, good balance of risk/reward
- 1:3 ratio: More premium collected, but even more unlimited risk
- 2:3 ratio: Reduced unlimited risk compared to 1:2
- 3:5 ratio: Further reduced risk, smaller potential profit
Choosing Strikes and Expiration
Strike Selection
- Long strike: Usually at-the-money or slightly in-the-money
- Short strikes: At your target price where you expect the stock to settle
- Width between strikes: Wider spreads mean higher maximum profit but require larger moves
Expiration Selection
- 30-45 days: Provides good theta decay on shorts without excessive risk
- Weekly options: Higher gamma risk but faster resolution
- Longer dated: More time for the stock to move but slower decay
Ratio Spread vs Vertical Spread
| Feature | Vertical Spread | Ratio Spread |
|---|---|---|
| Options Quantities | Equal (1:1) | Unequal (1:2, etc.) |
| Entry Cost | Usually debit | Often credit or low debit |
| Maximum Risk | Defined (spread width) | Unlimited on one side |
| Maximum Profit | Spread width - debit | Can be much higher |
Tips for Success with Ratio Spreads
- Know your breakevens: Calculate both upside and downside breakevens before entering
- Use in high IV: Elevated volatility makes the extra shorts more valuable
- Have an exit plan: Know exactly when and how you will exit if challenged
- Position size conservatively: The unlimited risk requires smaller positions
- Monitor actively: These are not set-and-forget strategies
- Consider the backspread conversion: Know how to flip your position if wrong
Common Mistakes to Avoid
- Ignoring the unlimited risk: Many traders focus only on the profit potential
- Wrong directional bias: A call ratio spread loses big on huge rallies
- Too wide strikes: Requires enormous moves that rarely happen
- No exit plan: Holding through breakevens leads to catastrophic losses
- Overleveraging: Trading too many contracts given the unlimited risk
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Summary
Ratio spreads offer a way to profit from moderate directional moves with minimal or no upfront cost. By selling more options than you buy, you collect extra premium that reduces your cost basis. However, this extra premium comes with a critical trade-off: unlimited risk beyond your short strike. The key to success with ratio spreads is understanding this risk, having clear exit plans, and being prepared to convert the position if the market moves against you. When used correctly in high implied volatility environments with realistic price targets, ratio spreads can be powerful additions to your trading arsenal.
Want to learn the opposite strategy? Check out our guide on backspreads which flip the ratio for unlimited profit potential. Or explore diagonal spreads for another advanced approach.