What is a Ratio Spread?

We spend a great deal of our earnings seasons trades using back ratio spreads. Back ratio spreads allow us to take advantage of implied volatility spikes as well as the likelihood of larger moves without the major downside of high probability to exposure.

WHAT IS A RATIO SPREAD?

A ratio spread allows us to purchase one long option (which can be either a put or a call) and use the sale of an option with a strike further away to pay for it but by a ratio of 2 or more.

A typical back ratio will look like this –

Buy AAPL APR 555 calls; and for each APR 555 call we buy, we will sell 2 APR 565 calls
The strikes do not have to be a designated distance away….that depends on the type of strategy you are using to set up the trade….but they will be further out of the money that the long strike.

The resulting trade above will usually result in a credit to your account, rather than a debit that you might pay for an ordinary long call spread.

WHY WOULD I WANT TO TAKE THIS TRADE?
This trade will be a credit to my account and as long as my short strikes (the ones I sold) do not drift very far into the money, I will have a green trade. Back ratios that are well positioned give us a tremendous amount of cushion while leaving us open to capture gains from larger moves.

WHAT ARE THE BENEFITS OF A RATIO SPREAD?
A back ratio allows us to have a large sweet spot from which we can collect profits. Let me explain.
Let’s say I take the above back ratio spread for a credit of .95 – that’s 95cents
That means for each back ratio spread (the purchase of one option and the sale of 2 options further out of the money), I will have $95 in my account.

Here are the possible outcomes –
1) the stock does nothing at all in terms of movement – I make my $95 per ratio spread because everything expires worthless
2) the stock falls through the floorboard – I make my $95 per ratio spread because everything expires worthless
3) the stock moves into 565 but does not go past 565 – I make my $95 per ratio spread AND $1000 for each ratio spread because I can buy at 555 (the strike I own) and sell at 565 – which gives me $10 of movement that is mine. This is THE SWEET SPOT
4) the stock moves past 565 but not past 575 – I make my $95 per ratio spread but I breakeven else where because the profit I made from 555 to 565 got taken back because the naked side moved $10 and took all my profit
5) the stock moves well past 575.95 – My credit is taken up – the $95 I collected, and all the profit I made between 555 and 565. I will be underwater at the 575.95 stock price

As you can see there is only one way out of five to lose money, which makes the back ratio an extremely attractive trading solution

WHAT ARE THE DRAWBACKS TO THE RATIO SPREAD?
From the example above you can see that choosing the incorrect strikes to be short can be most detrimental if a chart moves well past anticipated regions.
The trading strategy also uses margin; smaller accounts or accounts not approved for margin cannot do these trades.

There are a number of variations of the ratio – but it is by far, my favorite type of trade through earnings as the upside is magnified and the downside is minimized as I do know where to put these strikes so that we dont’ get into trouble

Here’s a video created by Dennis Mooney that analyzes the back ratio and a custom back ratio called the sunny side up

http://youtu.be/5WrXoudkQyE

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