How to set up ratio spreads

Venkatesh Bangaruswamy | Updated on: Nov 27, 2021
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Ratio spreads can significantly cut your cost because you collect premiums

A spread refers to strategy where you buy one strike and short another strike. The objective is to reduce cash outlay as the premium collected on the short call reduces the cost of the long call. Sometimes, setting up a ratio spread could be beneficial. In our earlier discussion, we showed how to setup specialized ratio spreads such as the bull ratio spread. In this article, we discuss when to setup ratio spreads.

Time-decay capture

You can setup a ratio spread by going long a strike and short more contracts of another strike option. Typical ratio would be one long contract to two short contracts (1x2).

Suppose you expect the Nifty Index to move sideways or rebound somewhat. You buy one contract of next-week 17500 strike call and short two contracts of next-week 17700 call. With 17500 call trading for 153 points and 17700 call trading for 73 points, you can setup the position for a net debit of seven points.

Ratio spread helps you significantly reduce your cost because you collect premiums from two short contracts as opposed to paying for one long position. The level of profit depends on the speed with which the index moves up.

The slower the better because the short options will generate gains from time decay. For instance, if the Nifty index moves to 17600 (one tradable strike from long call) three days after you setup the position, gains could be just three points compared to 42 points if the index reaches 17600 three days before expiry. It is, therefore, beneficial to setup a ratio spread closer to option expiry.

Ratio spreads can also be setup for net credit. You can do this when you have a view that the underlying is likely to move sideways and believe that current implied volatility is high. In the above scenario, that would mean setting up one long position with 17500 call and two short positions with 17600 call. With 17600 call trading at 107 points, the ratio spread can be setup for a net credit of 61 points. This spread will generate profits if the Nifty Index sits at 17600 at the expiry of the options or moves slowly to 17600 closer to expiry. The argument is similar on the downside) when you setup ratio put spreads.

You can also ratio a calendar spread and a diagonal spread. A ratio calendar spread involves going long one contract of next-week (or next-month) strike and short two contracts of near-week (near-month) strike. A diagonal ratio spread is different from calendar ratio spread in that it involves two different strikes. Note that the next week (next-month) contract will trade at a greater premium than the near-week (near-month) contract for the same strike. Yet, because of a 1x2 or higher ratio, even a calendar ratio spread can be setup for a net credit. For calendar and diagonal ratio spreads, the view should be that the underlying is unlikely to move above the short strike during the life of that contract.

Optional reading

If you expect the underlying to move sideways, the short strike can be closer to the long strike- the closer the strikes, the greater the net credit. The choice of ratio depends on what ratio allows you to set up the spread for a net credit with least number of short contracts.

Because ratio spreads work well for side way movement in the underlying, the position gains marginally from positive delta on the long option and significantly from time decay on the short options. That is why these spreads are more beneficial to setup when you expect implied volatility to decline. This is because time value of an option consists of time to maturity and implied volatility. So, a decline in implied volatility along with the option approaching maturity means that time decay will accelerate.

The author offers training programmes for individuals to manage their personal investments

Published on November 27, 2021

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