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Put Ratio Spread - An Option Trading Strategy

Today, we shall learn about the put ratio spread options strategy on this page. In this strategy, traders buy options at a higher strike price and sell more put contracts at a lower strike price, having the same underlying asset. It is a multi-leg, neutral strategy in which the risk is not defined and profit potential is limited. The strategy advantages from the fall in the underlying asset's volatility or no movement in the underlying asset stock price.


Put ratio spreads have three major components; one ITM long put purchased and two short puts sold at a lower strike price. All of these three contracts will have the same strike price and the same underlying asset. The put ratio spreads can generally be used for the debit or the credit depending upon the underlying stock's price, but the majority of the put ratio spreads are used for the credit.


Market outlook of the Call backspread option strategy?

Put ratio spread is a market neutral or slightly bearish. The strategy's profit is based on no movement in the underlying stock price. For traders to gain profit using this strategy, the stock price has to close near the short option strike price at the time of expiry.


When the put ratio spread is initiated, the profit is the amount of credit received in the form of a premium and the width spread between the long and short-put options if the price increases above the long put option strike price trader will realize a profit.


When to use the put ratio spread strategy?

Traders can use the put ratio option strategy when they believe that the market will fall moderately in the near term and will go only till the strike price of the sold contract. In other words, the put ratio can be used when traders expect an underlying asset's price will stay within a range of two strike prices at the time of expiry.


The main reason of this strategy is to reduce the overall cost and receive some upfront credit.


Setting up a put ratio spread:

A put ratio spread is the bear put spread having one additional put option contract sold at the same strike price. Here, the trader wishes that the price should close near or at the short put strike price at the time of expiry. It will allow the short contract to expire worthless, and the trader can still sell the long put option contract with its remaining intrinsic value.


The debit or credit while entering the strategy depends on how far ITM long put options contract is compared to the stock price and how far OTM the short put option contract is compared to the underlying asset.


How to enter the Put ratio spread?

To enter the put ratio spread, traders need to use the following order: Buy-to-open (BTO) ITM long put option contract and sell-to-open (STO) 2 OTM short out option contract at a price lower than the current stock price. All the contracts must have the same expiry dates.


The ratio of the contract must be 2:1, 3:2 or 3:1; only then will the strategy profit. Suppose the current stock price of the underlying asset is ₹ 48, then the trader can enter the strategy by:

  • Buy-to-open one long contract at ₹50 and

  • Sell-to-open two short contracts at ₹45.


Understating the put ratio spread diagram:

The diagram of the put ratio spread clearly shows the different outcomes based on the underlying asset's price.


If credit is received while entering the strategy, the credit amount plus the width of the strike price will be the trader's highest profit on this trade.


In this strategy, the highest profit and loss are both limited. If the stock-price exceeds the long put option contract at the time of expiry, all contracts will expire worthless, and the only profit on this trade would be the premium amount received initially.


Considering the above example, the stock's current price is ₹48. The trader enters the put ratio spread with a ₹50 long put option and two short put options at ₹45. Assuming the trader received ₹1 credit while entering the spread, traders will have the highest profit of ₹600. (The width of the spread ₹5 + ₹1 credit received. In this case, the short put expires worthless, and the long put will be sold for ₹600.


Assuming the other scenario, suppose the stock closes at ₹39 at the time of expiry. Here, the short put will cost ₹6 each to close (total ₹12), but on the other hand, the long put will be worth ₹11.


As we have already received ₹1 credit at the entry, the position will face the breakeven point ₹12 loss and ₹11 +₹1 profit which equals 0; this is the breakeven point of the position.


If the stock closes above ₹50 at the time of expiry, all the contracts will expire worthless, and traders will have ₹100 received initially as the profit.


Breakeven point of the put ratio spread strategy:

This strategy has two breakeven points as follows:

  • Lower breakeven point = Long put strike +/- total premium paid or received.

  • Upper breakeven point = short put strike price - the difference between the short and long strike prices (+ /-) premium amount paid or received.

Exiting the put ratio spread:

In case the stock closes at a price above the short option contract and within the long put strike price, the short contract will expire worthless, and the trader can sell the long put on its remaining value left.


In case the stock closes at a price above the long put option contract at the time of expiry, all three options will expire worthless, and the trader must close the position, or else he can get exercised or assigned.


Additional notes on this strategy:

  • Time decay or the theta impacts positively on the put ratio spread.

  • A trader can profit using this strategy if the implied volatility is low.

  • Traders may adjust the spread by extending the duration of the trade.


Conclusion:

So, we have seen how to combine the put option contract and make a spread and how traders can profit when there is no or minimum volatility in the underlying asset price. If you face any doubts or questions, kindly let us know at 8447445815 / 9909978783.



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