During the past few weeks, we have reviewed a number of "delta neutral" strategies commonly used by retail option traders. As you recall, a position with a delta-neutral outlook involves any combination of stocks, options and futures where the sum of deltas is equal to zero. The principle mathematical concept behind the non-directional approach with options is the way delta changes as an option moves further in or out of the money. Traders with a basic knowledge of pricing theory can estimate the change of the option's price relative to the movement in the underlying issue and use this information in conjunction with technical analysis of specific markets to identify positions where time decay is an advantage. We have already covered one delta-neutral technique that works well with lateral price trends; the short (credit) strangle. However another, lesser-known strategy in this category is the ratio spread.
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The Ratio Spread
A ratio spread involves the purchase of a number of options at one strike price and the sale of a greater number of options at a different (higher/calls; lower/puts) strike price. The options are either calls or puts, but not both, and the ratio of the spread is the number of short options divided by the number of long options. For example, the sale of three (3) XYZ FEB-$60.00 calls along with the purchase of one (1) XYZ FEB-$50.00 call produces a 1:3 ratio spread. Most traders think of the spread in terms of "1 to (n)" even when the ratio does not involve whole numbers such as 2:5 (which is really a ratio of 1:2.5). The reason for this approach is the ease with which two positions can be compared and it is much easier to evaluate the resultant leverage in this format; 1:2, 1:2.5, 1:3, 1:4, etc.
The ratio spread has a defined range within which a profit can be made at expiration. If the spread is initially established for a credit, there is no risk when the purchased options expire worthless; the profit (or loss) at expiration is constant with the underlying issue inside the long option's strike price. The maximum profit in the position occurs when the stock finishes the expiration period exactly at the strike price of the sold options. In contrast, the greatest risk in a ratio spread exists in the area beyond the sold options, where the debit may be theoretically unlimited. Here is the profit-loss diagram for a ratio call spread, which works well in range-bound markets with moderate volatility: