A put ratio spread is an advanced option trade and generally not suitable for beginners, but it can have its place within an option portfolio.
It is generally considered a neutral strategy, although it has the ability to make a profit in up, down and sideways markets.
Yes, it can make money no matter which way the market goes, the key is the timing!
The strategy involves buying a number of put options and selling more put options further out-of-the-money.
The trade is placed when the trader thinks the underlying stock will be stable or slowly move lower and finish around the short put strike at expiry.
A fall in implied volatility will benefit the trade and it can also be profitable if the stock moves up early in the trade.
The big risk with the trade is a sharp move lower early in the trade.
Let’s look at an example using Microsoft (MSFT).
Microsoft Ratio Spread Example
Buying the April 19 put with a strike price of $415 for around $4.00 and selling 2 of the April 19, $405 strike puts for around $1.75 would create a put ratio spread.
As we are selling 2 contracts at $1.75 the trade results in a net debit of $0.50 which is $50 premium.
This is the maximum loss above a stock price of $315. Basically, all the puts would expire worthless and the trader loses the $50 premium.
A tent-shaped profit zone exists between $395 and $415 with the maximum gain occurring at $405 and is around $950.
This is what the trade looks like as of today:
You can see the main risk in the trade is a drop in price early on. The blue line is the profit and loss at expiration and the purple line is the T+0 line. T+0 just means “today”.
So, we don’t want the stock to get into the profit tent too early. The trade starts with delta 0, which means the trade is delta neutral to start. This will change as the trade progress and may switch to negative delta if the stock stays above $415.
What about in 10 day’s time? How does the trade look then?
Looking a lot better for any price above $400.
One advantage of this trade type is it takes advantage of option skew. Notice the contract we are buying has lower volatility (19.64%) than the contract we are selling (20.64%). Buy low, sell high.
Company Details
Microsoft Corporation is one of the largest broad-based technology providers in the world. The company dominates the PC software market with more than 80% of the market share for operating systems.
The company's Microsoft 365 application suite is one of the most popular productivity software globally.
It is also now one of the two public cloud providers that can deliver a wide variety of infrastructure-as-a-service (IaaS) and platform-as-a-service (PaaS) solutions at scale.
Microsoft's products include operating systems, cross-device productivity applications, server applications, business solution applications, desktop and server management tools, software development tools and video games.
The company designs and sells PCs, tablets, gaming and entertainment consoles, phones, other intelligent devices, and related accessories.
Through Azure, it offers cloud-based solutions that provide customers with software, services, platforms and content.
The Barchart Technical Opinion rating is a 100% Buy with an average short term outlook on maintaining the current direction.
Long term indicators fully support a continuation of the trend.
Summary
This strategy should move fairly slowly, unless there is a sharp drop in the stock price.
As the trade involves naked options, it is not recommended for beginners.
You can do this on other stocks as well, but remember to start small until you understand a bit more about how this all works.
Mitigating Risk
With any option trade, it’s important to have a plan in place on how you will manage the trade if it moves against you.
A stop loss of $200 might make sense in this scenario. If Microsoft is below $405 as expiration draws near, there will be assignment risk
Please remember that options are risky, and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
On the date of publication, Gavin McMaster did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
