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Although a ratio spread simply involves the buying and selling of anuneven number of contracts, there are a variety of complex ways to imple-ment this strategy. For example, you can buy one OTM call option and selltwo call options that are even further out-of-the-money. You can also use aratio other than 1-to-2. For instance, you might buy two ATM options andsell three OTM options.
Many traders are willing to take the risk involved in shorting OTM op-tions because they believe that the probability of the market moving thatmuch is slim. Meanwhile, they are taking in a lot of premium. However, avolatile market can easily move enough to lose money on the uncoveredshort option. For that reason, we do not recommend this strategy, but wepresent it here in order to lead up to one of our favorite strategies—theratio backspread.
Ratio Call Mechanics
For example, during the month of February, let’s say you decide to createa ratio call spread by purchasing one July ATM 50 call at $4.50 and sellingtwo July XYZ 55 calls at $2.50. This trade will not cost you any money toplace because you’re spending $450 (4.50 × 100) to buy the 50 call and re-ceiving $500 [(2 × 2.50) × 100] in credit for selling the 55 calls. Thus, youare  receiving  a  credit  of  $50  to  place  the  trade.  This  trade  has  limitedproﬁt and unlimited risk. One of the short July OTM 55 calls is covered bythe long 50 call. If the market goes to 60, you would make 10 points on thelong call, lose 5 on the ﬁrst call, to lock in a net proﬁt of 5 points. How-ever, the second 55 call is uncovered and even though it was an OTM op-tion when the trade was initiated, there is some margin and risk on it. Ifthe market rises to 60, the second 55 call loses 5 points, reducing the netproﬁt to 0 points: (10 – 5 – 5 = 0).
The  maximum  proﬁt  of  a  ratio  call  spread  is  calculated  using  the
following equation:
Number of long contracts × (difference in strike prices × 100)
+ net credit (or – net debit)
In this trade, the maximum proﬁt is limited to $550: (55 – 50) × 100 +$50  =  $550.  However,  the  risk  is  unlimited  to  the  upside  above  thebreakeven point. The upside breakeven is calculated by using the follow-ing equation:
Lower call strike price + (difference in strikes × number of short contracts) 
÷ (number of short calls – number of long calls) + net credit (or – net debit)
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In this case, the upside breakeven is 60.50: 50 + [(55 – 50) × 2] ÷ (2 – 1)+ .50 = 60.50. There is no risk to the downside because the trade was en-tered as a credit. This trade is best entered during times of high volatilitywith expectation of decreasing volatility. The risk graph for this exampleis shown in Figure 9.1.
Ratio Call Spread
Strategy: Buy  a  lower  strike  call  and  sell  a  greater  number  of  higherstrike calls.
Market Opportunity: Look for a volatile market where you expect a slightdecline or a small rise not to exceed the strike price of the short options.
Maximum Risk: Unlimited to the upside above the breakeven.Maximum  Proﬁt: Limited.  [Number  of  long  contracts  × (difference  instrikes × 100) + net credit (or – net debit)].Upside Breakeven: Lower call strike price + [(difference in strikes × num-ber of short contracts) ÷ (number of short calls – number of long calls)] +net credit (or – net debit).
Margin: Required. Extensive due to the naked call.
FIGURE 9.1 Ratio Call Spread Risk Proﬁle
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Ratio Call Spread Case Study
Eastman Kodak (EK) has been trading in a range and you expect the stockto either stay in that range or make a modest move higher. The stock istrading for $29.50 per share during the month of June. In order to proﬁtfrom the stock’s sideways trading, let’s create a ratio call spread by sellingtwo October 35 calls for $1.75 each and buying one October 30 call for $3.You earn a credit of 50 cents or $50 when establishing this trade.
Ideally, after establishing the trade, the stock will move only graduallyhigher. If it rises above $33, but below $35, the short options will expireworthless and you can book a proﬁt on the long EK October 30 call. Themaximum gain occurs at exactly $35 a share at expiration. At that point,both EK October 35 calls expire worthless and the long call is worth $5. Inthat  case,  the  trader  keeps  the  $350  for  selling  the  two  short  calls  andearns another $200 in proﬁts from the long call. The total maximum gain istherefore $550. The risk proﬁle for this trade is shown in Figure 9.2.
If EK falls sharply, the trader can do nothing but let the calls expireworthless. In this example, that’s exactly what happened: The trade gener-ated a $50 return. The upside breakeven is equal to 40.50: [30 + (5 × 2)]+.50  =  40.50.  Losses  begin  to  develop  as  the  stock  moves  above  thebreakeven and are unlimited due to the naked short call. A move to $50 ashare, for instance, would result in a $950 loss. Therefore, the strategist istaking a signiﬁcant risk in order to earn a maximum of $550.
Ratio Call Spread Case Study
Strategy: Long 1 EK Oct 30 call @ $3.00 and Short 2 Oct 35 calls @ $1.75for a credit of $50.
Market Opportunity: EK is expected to move modestly higher, but notexplode to the upside.
Maximum Risk: Unlimited to the upside above the breakeven of $40.50a share.Maximum  Proﬁt: Number  of  long  contracts  × (difference  in  strikes  ×100) + net credit (or – net debit). In this case, the max proﬁt is $550: 1 ×(5 × 100) + 50.Upside  Breakeven: Lower  strike  +  [(difference  in  strikes  × number  ofshort options) ÷ (number of short calls – number of long calls) + net credit(or – net debit). In this case, the UB is 40.50: 30 + [(35 – 30) × 2 ÷ (2 – 1)]+.50.
Margin: Yes, due to sale of naked call.
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FIGURE 9.2 EK Ratio Call Spread (Source: Optionetics Platinum © 2004)
RATIO PUT SPREADS
A ratio put spread involves buying a higher strike put option and selling agreater  number  of  lower  strike  OTM  put  options  and  should  be  imple-mented in a bullish market. The maximum proﬁt of a ratio put spread iscalculated by multiplying the difference in strike prices by 100 and thenadding the net credit received. The maximum risk is limited to the stockgoing to zero and equals the lower strike price minus the difference be-tween the two strike prices plus the net credit times 100. The downsidebreakeven is calculated by dividing the difference in strike prices timesthe  number  of  short  contracts  by  the  number  of  short  contracts  minus
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the  number  of  long  contracts  and  subtracting  that  number  from  thehigher put strike price. Then, subtract the net credit received or add thenet debit paid.
A ratio put spread can be implemented when a slight fall in the marketis  anticipated  followed  by  a  sharp  rise.  This  strategy  works  well  in  thestock market, as stocks generally tend to move up in price. However, it isimportant to place this trade on only high-quality stocks. If the companyhas reported lower than expected earnings or bad news is released, exitthe position. A ratio put spread also works well in many futures markets,especially  during  seasonal  periods  when  prices  tend  to  go  up  (such  asheating oil in the winter months).
The main risk in ratio spreads comes from the uncovered short callor put. These options have unlimited risk. Watch the market closely andexit  or  adjust  the  trade  if  the  market  moves  to  the  strike  price  of  theshort options.
Ratio Put Spread Mechanics
Let’s create an example with XYZ trading at $50 a share in February thatconsists of going long one July XYZ 50 put at $4.50 and two short JulyXYZ 45 puts at $2.50 each. This trade creates a net credit of .50 or $50:[(2 × 2.50) – 4.50] × 100 = $50. The maximum proﬁt of a ratio put spreadis calculated by using the following formula:
(Difference in strike prices × 100) + net credit (or – net debit)
In this trade, the maximum proﬁt is limited to $550: (50 – 45) × 100 +$50 = $550. The maximum risk is limited because the stock can only fall tozero and is calculated using the following formula:
Lower strike price – (difference in strikes – net credit) × 100
In this example, the maximum risk is $3,950: 45 – [(50 – 45) – .50] ×100 = $3,950. The downside breakeven is calculated by using the follow-ing formula:
Higher strike price – [(difference in strikes × number of short contracts)
÷ (number of short contracts – number of long 
contracts)] – net credit (or + net debit)
In this example the downside breakeven is 39.50: 50 – [(50 – 45) × 2]÷ (2  –  1)  –  .50  =  39.50.  The  risk  graph  for  this  trade  is  shown  in Figure 9.3.
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FIGURE 9.3 Ratio Put Spread Risk Proﬁle
Ratio Put Spread Case Study
General Electric (GE) has been performing well and the stock is expectedto take a pause or perhaps trade lower. With shares near $23.40 in Febru-ary 2003, let’s short sell two January GE 20 puts at $2 and go long 1 Janu-ary 25 put at $4. The sale of the puts offsets the cost of the long put andthe trade is executed at even (without a debit or credit).
Ratio Put Spread
Strategy: Buy a higher strike put and sell a greater number of lower strikeputs.
Market  Opportunity: Look  for  a  market  where  you  expect  a  rise  orslight fall not to exceed the strike price of the short options.
Maximum  Risk: Limited  to  the  downside  below  the  breakeven  (as  thestock can only fall to zero). Lower strike price – (difference in strikes – netcredit) × 100.Maximum Proﬁt: Limited. (Difference in strikes × 100) + net credit (or –net debit).Downside Breakeven: Higher strike price – [(difference in strikes × num-ber of short contracts) ÷ (number of short contracts – number of long con-tracts)] – net credit (or + net debit).
Margin: Required. Extensive due to the naked put.
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After establishing the trade, the strategist wants to see shares of Gen-eral  Electric  edge  lower.  The  maximum  gain  occurs  at  expiration  if  thestock is trading for $20 a share. At that point, both GE January 20 puts ex-pire worthless and the long put is worth $5 a contract, or $1 more than theentry price. If so, the strategist earns $1 in proﬁts with the long call andkeeps the $4 in premium for selling the short puts. The maximum gain istherefore $500. The risk graph of this trade is shown in Figure 9.4.
If GE rises sharply, the strategist can do nothing but let the puts ex-pire worthless. In that case, the loss is equal to the commissions paid forthe trade. On the other hand, if the stock falls sharply, the losses can besubstantial.  The  downside  breakeven  is  equal  to:  higher  strike  price  –[(difference  in  strike  prices  × number  of  short  contracts)  ÷ (number  of
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FIGURE 9.4 GE Ratio Put Spread (Source: Optionetics Platinum © 2004)
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Ratio Put Spread Case Study
Strategy: Long 1 GE 25 Put @ $4.00 and Short 2 GE 20 Puts @ $2.00. Netdebit/credit equals zero.
Market Opportunity: Look for GE to trade modestly lower or sideways.
Maximum  Risk: Limited  to  the  downside  below  the  breakeven  (as  thestock can only fall to zero). Lower strike price – (difference in strikes – netcredit) × 100. In this case, the max risk is $1,500: [20 – (25 – 20) – 0] × 100.Maximum  Proﬁt: Limited.  (Difference  in  strikes  +  net  credit)  × 100.  Inthis case, the max proﬁt is $500: {5 × [(25 – 20) + 0]} × 100.Downside Breakeven: Higher strike – [(difference in strikes × number ofshort puts) ÷ (number of short puts – number of long puts)] – net credit. Inthis case, the DB is 15: 25 – [(5 × 2) ÷ 1] – 0.
Margin: Required. Extensive due to the naked put.
short contracts – number of long contracts)] – net credit (or + net debit),or $15: [25 – (5 × 2)] ÷ (2 – 1) – 0 = $15]. Losses begin to develop as thestock moves below the breakeven and are limited to the stock falling tozero.  In  this  case,  if  the  stock  falls  to  zero,  one  short  put  will  cover  thelong put and result in a $5 proﬁt. The other put will probably be assignedfor  a  $20  loss.  The  total  loss  would  therefore  be  $1,500.  Therefore,  thestrategist is risking $1,500 to earn $500 from this trade.
EXIT STRATEGIES FOR RATIO SPREADS
Whether trading call or put ratio spreads, it is important to remember thatthese strategies involve substantial risk for limited reward. The strategistwants  to  be  careful  because  these  types  of  spreads  involve  more  shortthan  long  options  and  therefore  involve  naked  options.  In  a  call  ratiospread, the risk is unlimited to the upside. If the underlying stock movesbeyond the short strike price before expiration, the strategist might wantto consider closing the position by buying back the short calls and sellingthe  long  call.  If  the  stock  drops,  do  nothing,  let  the  options  expire,  andkeep the net credit received for establishing the trade.
In  the  case  of  the  put  ratio  spread,  the  opposite  holds  true.  In  thatcase, a sharp move lower in the stock can result in substantial losses. Ifthe stock falls below the short strike price before expiration, the strategistmight consider closing the position by purchasing back the short puts andselling the long put. If the stock moves higher, do nothing, let the optionsexpire, and keep the credit.
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CALL RATIO BACKSPREADS
Ratio backspreads are one of my favorite strategies for volatile markets.They are very powerful strategies that will  enable you to limit  your riskand receive unlimited potential proﬁts. These strategies do not have to bemonitored very closely as long as you buy and sell options with at least 90days (the longer the better) until expiration. I like to call them “vacationtrades”  because  I  can  place  a  ratio  backspread,  go  on  vacation,  and  noteven worry about it. For some traders, ratio backspread opportunities arehard to ﬁnd. Perhaps they are looking in the wrong places. It is difﬁcult toﬁnd ratio backspread opportunities in highly volatile markets with expen-sive stocks or futures. For example, you will rarely ﬁnd them in the S&P500 futures market. This index is simply too volatile and the options aretoo expensive. Focus on medium-priced stocks (between $25 and $75) orfutures. These trades can be quite proﬁtable, so be persistent. They’re outthere—just keep looking.
Additionally, when looking for the right market for a call ratio back-spread,  scan  for  markets  exhibiting  a  reverse  volatility  skew.  In  thesemarkets,  the  lower  strike  options  (the  ones  you  want  to  sell)  havehigher  implied  volatility  and  can  be  overpriced.  The  higher  strike  op-tions (the ones you want to buy) enjoy lower implied volatility and areoften  underpriced.  By  ﬁnding  markets  with  a  reverse  volatility  skew,you can capture the implied volatility differential between the short andlong options.
A  ratio  backspread  strategy  involves  buying  one  leg  and  selling  an-other in a disproportionate ratio that does not create a net debit. The fol-lowing seven rules must be diligently observed to create an optimal ratiobackspread trade:
1. Choose markets where volatility is expected to increase in the direc-
tion of your trade.
2. Avoid  markets  with  consistent  low  volatility.  If  you  really  want  toplace a ratio backspread in a market that does not move, pay close at-tention to rule 4.
3. Do not use ratios greater than .67—use ratios that are multiples of 1:2
or 2:3.
4. If you choose to trade a slow market, a .75 ratio or higher is accept-able only by buying the lower strike and selling the higher. However,there is more risk.
5. To create a call ratio backspread, sell the lower strike call and buy a
greater number of higher strike calls.
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6. To create a put ratio backspread, sell the higher strike put and buy a
greater number of low strike puts.
7. Try to avoid debit trades. But if you do place a ratio backspread with a
debit, you must be able to lose that amount.
Call Ratio Backspread Mechanics
As  previously  stated,  a  call  ratio  backspread  involves  selling  the  lowerstrike call and buying a greater number of higher strike calls. For exam-ple, let’s pick a ﬁctitious market (it doesn’t matter which market as longas  it  is  volatile)  with  strikes  starting  at  40,  45,  50,  55,  and  60.  The  ATMcalls are at 50, which means that the current price of the underlying mar-ket equals $50 also. Now, according to rule 5, the ﬁrst part of a call ratiobackspread is to sell the lower strike call. Which is the lowest strike callhere? The 40 is the lowest strike call. Now, the other part of the rule tellsme to buy a greater number of higher strike calls. Let’s buy an option tobuy this market at $60 because we think the market is going to reach $65.Am I going to pay less for this call than for the 40, or more? I’m going topay  less  because  now  I’m  speculating  that  the  market  mood  is  bullish.Speculating  on  market  direction  is  one  of  the  main  reasons  why  manypeople  lose  money  when  they  trade  options.  However,  I’m  going  to  goahead and speculate that the market is going to go to 65, even though it’sonly at 50 right now. Furthermore, I’m going to pay less for a 60 optionthan a 55 strike. As the strike price goes up, the premiums of the ITM op-tions also go up, as they are more and more valuable. If our market is cur-rently  trading  at  50  but  it’s  starting  to  rise,  the  price  of  the  60-strikeoption will also rise.
Now  let’s  introduce  the  delta  into  this  situation.  The  delta  is  theprobability an option has of closing in-the-money at expiration. If a 50-strike option is at-the-money, which way can the market go? The marketcan move in either direction, which means there is a 50 percent proba-bility of it closing in-the-money. Obviously, a price that’s already in-the-money has a higher probability of closing in-the-money than somethingthat’s out-of-the-money. Therefore, the delta for an ITM option is higherthan  the  delta  for  the  ATM  option  or  an  OTM  option.  The  higher  theprobability  an  option  has  of  closing  in-the-money,  the  higher  its  pre-mium. This relationship enables a trader to create trades that are virtu-ally  free  of  charge.  Ratio  backspreads  take  full  advantage  of  thisrelationship.  It’s  a  relatively  simple  concept.  As  the  underlying  instru-ment’s  price  changes,  the  option  deltas  change  accordingly.  For  exam-ple, our 40-strike option has a higher delta than one with a 60-strike, andtherefore a higher premium as well.
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Let’s set up a call ratio backspread using XYZ, which is currently trad-ing  at  50.  To  satisfy  the  rules,  let’s  sell  a  40  call  and  buy  more  of  the  60calls in a ratio of 2-to-3 or less. This trade would receive a credit on theshort 40 call and a debit on the long 60 calls. However, we have limited therisk of the short 40 call by offsetting it with one of the long 60 calls andcan still proﬁt from the other long 60 call.
As  previously  stated,  determining  risk  is  the  most  important  part  ofsetting up any trade. The risk of this trade can be calculated using the fol-lowing option premiums:
Call
Price
6055504540
$  60$  70$  80$  90$100
If we sell one 40-strike call option and buy two of the 60-strike call op-tions, we have a debit of $20: 100 – (2 × 60) = –$20. But if the prices rise,we’ll make more money on the 60-strike calls than on the 40-strike call. Ifthe  market  falls,  the  out-of-pocket  cost  of  placing  the  trade  is  the  maxi-mum risk. The most we can lose is $20 on the downside.
The trick to creating an optimal trade is to avoid risk by using a ratiothat makes the trade delta neutral. In this way, it is possible to place a tradefor free at no net debit. That’s right! You can create ratio backspreads thatdon’t cost a penny (except for commissions) and still make healthy proﬁts.You can do this by offsetting the credit side with the debit side so that theycancel each other out and you don’t have to spend any money out-of-pocket.In this example, you can create a 2 × 3 ratio backspread at a $10 credit: [(2 ×100) – (3 × 60)] = +$20. This is the best kind of trade to place (especially ifyou’re 100 percent wrong about market direction), because you won’t loseany  money.  In  this  case,  as  long  as  the  market  breaks  down  below  the  40strike, both options expire worthless. However, there is some risk betweenthe 40 and 60 strike prices because the trade could lose more than it proﬁts.To ﬁgure out the most effective ratio, you have to accurately calculatethe net credit of a trade. This can be accomplished by calculating the fullcredit realized from the short options and dividing it by the debit of onelong option. You can then use up as much of the credit as you can to makethe most proﬁtable ratio.
Credit = Number of short contracts × short option premium × 100
Debit = Number of long contracts × long option premium × 100
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Once you have ﬁgured out the best ratio of the trade, you still have to
calculate your risk.
Risk = [(Number of short contracts × difference in strikes) × 100]
+ net debit paid (or – net credit)
Let’s  use  these  equations  to  determine  an  optimal  call  ratio  back-spread using XYZ trading at $50 during the month of February. Let’s cre-ate  a  call  ratio  backspread  by  going  short  1  XYZ  January  50  call  for$8.50  and  going  long  2  January  60  calls  for  $4.25  each.  In  this  case, we  are  using  long-term  equity  anticipation  securities,  or  LEAPS.  Ourshort  calls  give  us  a  credit  of  $850:  (8.50  × 100)  =  $850.  The  two  longcalls also cost $850: (2 × 4.25) × 100 = $850. Therefore, this trade can beplaced at even.
While the call ratio backspread using one short 50 call and two long60  calls  can  be  set  up  at  even,  let’s  consider  what  happens  when  we  in-crease it to a 2-to-3 ratio. By going short two XYZ January 50 calls at $8.50and  going  long  three  XYZ  January  60  calls  at  $4.25,  we’ll  receive  $1,700from the sale of the short calls and pay only $1,275 to buy the long callsfor a net credit of $425: (2 × 8.50) – (3 × 4.25) = $425. Actually, we couldalso buy four XYZ January 60 calls against the credit received for sellingthe three XYZ January 50 calls ($1,700 ÷ 425 = 4), but the ratio of 2 to 3 isrecommended in the guidelines as a more optimal ratio for a ratio back-spread. Therefore, let’s create a ratio backspread with a 2-to-3 ratio, whichsatisﬁes rule 3 and garners a net credit of $425.
The next step is to take a look at this trade’s risk proﬁle. This riskgraph  (see  Figure  9.5)  shows  the  trade’s  unlimited  potential  reward  ifXYZ moves higher. It also reveals that the maximum risk of $1,575