Ratio Put Spread

What Is a Ratio Put Spread?

Buy 1 put with higher strike price, sell 2 or more puts with lower strike price.

All contracts of a ratio put spread should have the same expiration month. The ratio put spread is similar to a long put spread, but with one or more extra short puts. These extra puts can increase potential profit, but are uncovered. As the stock price decreases the investor is exposed to increased risk on the downside. Depending on the expiration month selected, and whether the strike prices are in-, at-, or out-of-the-money, this spread may be put on for either a net debit or a net credit for the transaction.

Why Use Ratio Put Spreads?

You expect a steady underlying stock price over a certain period of time, and want to speculate about where it will be at expiration - i.e., at the short puts' strike price. You want to profit from the short contracts' time decay, but want to limit your overall short put risk with a long put position.

Market Opinion of a Ratio Put Spread

This is considered a neutral strategy.

You don't want the stock price to move much in either direction while you have this position on.

Maximum profit potential: limited

You should see maximum profit if the underlying stock closes exactly at the short puts' strike price at expiration. If this happens, your short contracts will expire at-the-money and worthless. The long one will be in-the-money and have intrinsic value.

Loss potential: downside substantial; upside limited to net debit paid for the spread

As the underlying stock price falls below the short puts' strike price, your uncovered short contract(s) expose you to an unlimited loss potential. If the stock closes above both strike prices at expiration, all contracts will expire out-of-the-money and worthless and your loss is limited to the net debit paid for the spread. Under the same circumstances, if you established the spread for a net credit you keep it and the position makes a small profit.

Break-even point (B.E.P.) at expiration:

Downside B.E.P. = underlying stock price = short strike – (maximum profit ÷ number of naked puts)

If debit paid for spread: upside B.E.P. = underlying stock price = long strike price – debit paid

Possible Scenarios of Ratio Put Spreads

Positive Scenario of a Ratio Put Spread

At expiration, the underlying stock closes exactly at the short puts' strike price. In this case your long put will have intrinsic value, the short puts will expire at-the-money and worthless, and you make your maximum profit.

Negative Scenario of a Ratio Put Spread

The stock price decreases significantly and the value of your uncovered your short puts(s) increases.

How does Volatility impact a Ratio Put Spread?

An increase in implied volatility is generally a negative factor in a spread; a decrease is generally a positive one. Remember, you are short more puts than you are long.

Time Decay and Ratio Put Spreads

The effect of time decay varies. When stock is at the short puts' strike price the effect can be positive – when at the long put's strike price the effect can be negative.

Example Ratio Put Spread:

Open a free account today.

Please note: All or part of your investments using neutral strategies has greater risk of loss in volatile markets.