Ratio spread

Ratio spread

The ratio-spread is a strategy in options trading that involves buying some number of options and selling a larger number of other options of the same underlying market and (usually) the same expiration date, but of a different strike price.

Ideally, this strategy should be used when either A) the implied volatility of the options expiring in a particular month has recently moved sharply higher and is now beginning to decline, or B) the trader believes for whatever reason that the underlying market of the option(s) will move steadily in his favor during the life of the option. The trader will use call options in this strategy if he believes the underlying market will move steadily higher, and put options if he believes the market will move steadily lower.

In the case of call options, the trader will buy some number of options having striking price X and write (sell) a larger number of options having striking price Y, where Y is greater than X. In the case of put options, the trader will buy some number of options having striking price A, but write (sell) a larger number of options having striking price B, where B is less than A.

The "straight" ratio-spread describes this strategy if the trader buys and writes (sells) options having the same expiration. If, instead, the trader executes this strategy by buying options having expiration in one month but writing (selling) options having expiration in a different month, this is known as a ratio-diagonal trade.

As with all option spreads, the trader in a ratio-spread will strongly prefer to buy options having a distinctly lower implied volatility than the options he is writing (selling).

The world's most widely read author on option trading, Larry McMillan, offers a very fine and detailed description of this strategy in his book "Options as a Strategic Investment", in both the 3rd and 4th editions of the work. The less well-known author, S. A. Johnston, offers very sound tactical commentary on this strategy in his book "Trading Options to Win".

ee also

*Options spread

References

* cite book
last = McMillan| first = Lawrence G.
title = Options as a Strategic Investment
edition = 4th ed.
publisher = New York : New York Institute of Finance
year = 2002
id = ISBN 0-7352-0197-8


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