Negative ratio spread

Market view

Establishing a negative ratio spread is a suitable strategy when you believe in a moderate downturn in a stock or an index until a certain date, preferably the option’s expiry day. 
 

Construction

You establish the negative ratio strategy by buying put options with a higher strike price and at the same time writing twice as many put options at a lower strike price. The advantage with establishing a negative ratio spread is that you will have a lower cost of capital to establish the position. On the other hand more margins will be required and you will face a higher risk if the market drops substantially.


Example:
It is the 14th of March and the ABC index level is 800. Your stock portfolio has gone up 30 percent since New Year with support from falling market interest rates and a strong US dollar. Your belief is however that the market has risen too heavily, and find it likely that the market will adjust downwards amply six percent to an index level of around 750 until expiration on the forth Friday of April.

Since you want to protect the profit you have made from your stocks, but at the same time do not want to take positions against a rising market, you find it to expensive just to buy naked put options on the ABC index. To be able to establish a protective option position to a low capital cost you choose to construct a negative ratio spread instead by buying 10 put option contracts at a strike price of 800 at 3,000 per contract, and at the same time write twice as many put options at strike price 750 at an income of 1,200 per contract. This gives you a net cost of (10 x 3,000) – (20 x 1,200) = 6,000. 
 

Results on the expiration day

The outcome from different index levels on the expiry day is shown in the table below:
 

Profit, loss and break-even

The maximum profit from the above position amounts to 44,000. It arises at a closing level of exactly 750, corresponding to an decline of 6,3 percent from index 800. The maximum profit is calculated as the difference between the two strike prices minus the net premium multiplied by 1,000, i.e. (800 – 750 – 6) x 1,000 = 44,000. Since you paid 6,000 for the position, that corresponds to a return of 733 percent on invested capital during that period. At an index level below 750 your profit will start to decrease and at an index value below 706 it will turn into a loss. The maximum loss is only limited by the fact that a stock price or an index level cannot be negative.

Thanks to the strategy’s low net cost you will reach the position’s break-even at an index level of 794, corresponding to a decline of 0.8 percent from an index value of 800. If you had bought put options only at a strike price of 800 at 3,000 per contract instead, your break-even would have been first at 770.
 

Realization of profit

The negative ratio spread strategy is what we call an expiry day strategy, since it is not possible to realize the maximum profit, with a correct market opinion, until expiration. That is due to the fact that when the market drops both the value of your purchased and written options will increase, and it is not until the expiry day that the difference between them will be maximal, i.e. 5,000 per contract. The reason for this is that with a correct market opinion your written options will be closer to pari than your purchased options, and therefore they will always contain more time value. It is first on the expiry day that the time value of all the options will be zero. 
 

Follow-up and protection

An appreciated advantage with buying a negative ratio spread is the high potential return on invested capital. Despite the theoretical risk of loss in the position, the probability is also high that you can, with a thought through follow-up, minimize the loss if it turns out that you were wrong in your market opinion. If you notice that the market, contrary to your market opinion, begins to move up or lies still you have several possible actions to take, for example: 

1. If you believe that the market will continue to rise, or at least not drop below 750, you can sell your purchased put options with a strike price of 800 and lie still with your 750 naked written. Please observe that naked written put options are only limited by the fact that an index value can never be negative.
    
2. If you consider point 1 above to be too risky you can also buy back half, or all, of your written put options as soon as you notice that your market opinion was incorrect.
    
3. If you, despite the rise, still believe in falling stock levels you can turn your ratio spread into a negative ladder by buying 10 put option contracts at a strike price of 820 and at the same time sell your purchased put options with a strike price of 800 and in addition write another 10 put options at a strike price of 800. At the same time you buy back 10 of your written put options with a strike price of 750. You will then have a position consisting of 10 purchased put options with a strike price of 820 and 10 written put options at a strike price of 800 and 750 respectively.

If instead, the problem is that the market drops below 750 and your profit from the ratio spread starts to decrease, you may for example:

 

1. Turn the position into a negative ladder by buying back 10 contracts of your written put options at strike price 750, and instead write an equal number of contracts at a lower strike price, for example 720.
2. Sell 10 index future contracts, at the latest, at an index value of 750. In that case you are fully protected against the market continuing to drop. Please observe that you still risk a loss from the future position if the index value rises above the price you sold the futures for.  

Advantages with a negative ratio spread 

• Potentially very high return on invested capital
• Low break-even
• Several possibilities to strongly reduce the loss having had an incorrect market opinion

Drawbacks with a negative ratio spread 

• High risk of loss at substantial declines, demands careful surveillance
• Hard to realize the maximum profit before the expiry day
• Relatively high transaction costs due to many “option legs” in the position 

Choice of strike prices
 

Which strike prices to choose depends on how much percent you think an index or a single stock will drop, and how high a risk you are prepared to take. When you establish a negative ratio spread, the higher risk you are prepared to take when levels fall, the higher is the probability that the position will reach its maximum profit at some point during the time to expiration. At the same time your cost to establish the position becomes lower, and your return on invested capital is therefore higher.

As an example we can compare the position in our example above with a case where you instead make a broader negative ratio spread by buying 10 put option contracts at strike price 800 at a price of 3,000 per contract. This will be 30 000 in total, and at the same time you will write twice as many put option contracts at strike price 720 at a cost of 600 per contract, 12,000 in total. In this case your invested capital is 18,000 and your maximum profit (800 – 720 – 18) x 1,000 = 62,000. Now, with a decline of 2.2 percent, from index 800 to 782, you will begin to profit from the position, and with a decline of 10 percent you will reach your maximum profit. On the other hand, the probability is now lower that the index value should drop below your lower strike price of 720, and at an index value below 658 your profit will be turned into a loss.