DESCRIPTION: A ratio spread is a modification to any of the standard strategies described. Instead of using options on a 1 x 1 basis, different numbers of options are used for each leg of a trade to create unique payoff patterns. (Example 1 x 3 Ratio Call Spread) The following will discuss a 1 x 3 ratio call spread as an example of how ratios change the dynamics of a traditional vertical debit spread trade.
MOTIVATION: The investor who buys a ratio call spread is looking for the underlying instrument’s price to rally, but only to a point. More often than not, a ratio call spread generates a debit, but that up-front capital commitment is less than one would pay when using a 1 x 1 spread. Since the premium paid is less, the return drag caused by time decay is also lower. Changing the ratio and the strike prices selected can generate a credit that allows the structure to have a positive carry. The investor is willing to risk that the underlying instrument’s price might move farther than expected.
| Action | Quantity | Expiration | Strike | Type | Price | Net |
| Sell | 3 | 0.25 Years | $30.00 | Call | 0.37 | -$1.11 |
| Buy | 1 | 0.25 Years | $25.00 | Call | 1.74 | $1.74 |
| Credit | $0.63 |
OUTLOOK: The buy of a ratio call spread is looking for a measured rise in the underlying instrument’s price over the term of the options selected. They want the share price to rise, but they do not want it to increase too much.
MAXIMUM GAIN: Higher Strike – Lower Strike – Premium Paid
The investor captures the maximum gain if the underlying instrument’s price sits at the strike price of the option sold at expiration. If the price continues to rise, the initial profits shrink and may turn to losses.
MAXIMUM LOSS: Infinite
Since the underlying instrument’s price does not have an upside bound, the loss on this structure is unlimited as well.
BREAKEVEN: Lower Strike Price + Premium Paid, The Upper Strike Price + (Ratio -1)(Distance Between the 2 Strikes) – Premium Paid
If the trade takes the form of a debit spread, there are two breakeven levels. Both breakeven levels lie above the current price of the underlying instrument. The first breakeven levels reside just above the lower strike price by an amount equal to the premium paid to structure the trade. As the share price rises, the trade structure becomes profitable. But if it rises too far, the calls sold overwhelm the call purchased, and the trade move to a loss.
VOLATILITY: Negative. The long call ratio spread is a bullish structure but short volatility. This strategy performs best if the price of the underlying rises at a measured pace. A big volatile up move will result in significant losses. A big explosive down move in price will result in a modest loss equal to the premium paid if a premium is paid upfront.
TIME DECAY: Negative. While time decay in a ratio call spread is less than a 1 x 1 call spread, it still exists unless the trade is structured such that a large enough option is sold to generate a credit large enough to cover the premium paid o the option purchased.
ASSIGNMENT RISK: May or May Not Be Significant. An American call option allows the owner of that call to take a position at any time. If the stock undergoes a huge upward move, the owner of the upside calls my exercise and demand delivery. The owner of the ratio call spread must deliver the underlying asset.
EXPIRATION RISK: Can be Significant. When the price of the underlying security is trading near the strike price of the upside call, the investor does not know if they will ask to deliver stock. They will only be informed of this demand on the day after delivery is requested