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 be a discussion of a 1 x 3 ratio call spread as an example of how ratios change the dynamics of a trade.
MOTIVATION: The investor who buys a ratio call spread is look for the price of the underlying instrument to rally, but only to a point. The advantage of using a ratio over a 1 x 1 is that it lowers the upfront cost (debit) and reduces the return drag caused by time decay. The investor is willing to take the risk that the price might move farther than expected.
OUTLOOK: The buy of a ratio call spread is look for a slow measured rise in the price of the underlying instrument over the term of the options selected. They want the share price to rise, but they do not want it to rise too much.
MAXIMUM GAIN: Higher Strike – Lower Strike – Premium Paid
The maximum gain is achieved if the price of the underlying instrument sits at the strike price of the option sold at expiration. If the price continues rise, the gains shrink and can turn to losses.
MAXIMUM LOSS: Infinite
Since the price of the underlying instrument does not have an upside bound, the loss on this structure is unlimited as well.
BREAKEVEN: Lower Strike Call + Premium Paid
The breakeven levels reside just above the level of the lower strike by an amount equal to the premium paid to structure the trade.
VOLATILITY: Negative. This strategy performs best if the price of the underlying rises slowly and steadily. A big volatile up move will result in large losses. A big volatile down move in price will result in a modest loss equal to the premium paid.
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 are 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 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 asked to deliver stock. They will only be informed of this demand on the day after delivery is requested