Positive ratio spread

Market view

Establishing a positive ratio spread is a suitable strategy when you believe in a moderate rise in a share or an index up to a specific date, preferably the expiry day of the option.

 

Construction

To establish a positive ratio spread you buy call options with a lower strike price and at the same time you write more (usually twice as many) call options at a higher strike price. The advantage with establishing a positive ratio spread is that you will have a lower cost of capital to establish the position. On the other hand it will imply higher margin requirements and you will have a larger risk at heavy upward movements.


Example:
It is the 28th of December and the index level is 600. The stock market has fallen 20 percent since the summer, partly due to financial instability in Asia. However, your opinion is that the market has slightly overreacted and find it likely that the market will rise about 5 percent, corresponding to an index level of 630 up to expiration on the fourth Friday of January. As extra support to your market opinion you know that January is historically a very strong month for the market.

Since you find the market situation to be a little uncertain after all, you find it too expensive to buy call options, especially since volatility was high last month which has made the option prices reach historically high levels. Instead you choose to establish a ratio spread by buying 10 contract call options with a strike of 600 for 2,000 per contract and at the same time write twice as many contract call options with strike price of 630 to a income of 800 per contract. This gives you a net cost of (10 x 2,000) – (20 x 800) = 4,000. The outcome at different index levels at expiration is shown in the table below.
 

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 26,000. That occurs at a closing level of exactly 630, corresponding to a rise of 5 percent. The maximum profit is calculated as the difference between the two strike prices minus the net premium multiplied by 1,000, i.e. (630 – 600 – 4) x 1,000 = 26,000. Since you have paid 4,000 for the spread this equals a profit of 650 percent on invested capital during the period.  

At an index level above 630 your profit will start to decrease and at levels above 656 it will turn into a loss. The maximum loss is theoretically unlimited since there is no upper bound for an index level.
 

Thanks to the low net cost of this strategy you will reach the positions break-even already at a closing level of 604, corresponding to a rise of a little less than 0,7 percent from an index level of 600. If you instead had bought only the call option at a strike price of 600 for 2,000 per contract your break-even would have been first at an index level of 620.  

Realization of profit

The positive ratio spread strategy is, just as the price spread and the ladder, a so called expiry day strategy, since normally it is not possible to realize the maximum profit until the expiry day. The reason for this is that when the market rises, both the value of your purchased and written options will increase, most likely by different amounts, and it is not really until the expiry day that the difference between them will be 2,000 per contract. This is due to the fact that your written options will be closer to pari than your purchased options, and thereby always contain more time value. It is not until the expiry day that the time value in all options will be zero.

 

Follow-up and protection

The positive ratio spread strategy can, just as the positive price spread, give you a very high profit on invested capital, and with a high probability you can avoid large losses if it turns out that your market opinion was incorrect. If you notice that the market, contrary to your market opinion, starts to move down or stands still, you have several options depending on your new market opinion and risk aversion. For example:

 

1. If you believe that the market will continue to move down, or at least not rise over 630, you can sell your purchased call options with a strike price of 600 and not move with your 630 naked written calls. Please observe that the risk is unlimited with naked written call options.
2. If you consider the above strategy to be too risky, you can either buy back half, or all of your written options as soon as you notice that your market opinion was wrong.
3. If, despite the market downturn, you are still positive you can, for example, turn your ratio spread into a ladder. You cab do this by simultaneously buying 10 call option contracts with a strike price of 580, sell your purchased call options with a strike price of 600 and write another 10 call options with a strike price of 600. Finally, you can buy back ten of your written call options with a strike price of 630. Thereafter, you will have a ladder consisting of 10 purchased call options with a strike price of 580 and 10 written call options at 600 and 630 respectively.

If, instead, the problem is that the market rises over 630 and your profit from the ratio spread thereby begins to fall, you can also at this point turn your position into a ladder by:

 

1. Buying back 10 contracts of your written call options at a strike price of 630 and instead write call options higher up, for example at 640.
2. Buying 10 contracts of index futures at an index value of 630. In that case, you are completely protected against the risk of continuing market rises. Please observe that you now risk a loss from your futures position if the future price falls below the price you paid.

Advantages with a positive ratio spread 

• Possibility of a very good return on invested capital
• Low break-even
• Several opportunities to considerably reduce the loss with incorrect market opinion

Drawbacks with a positive ratio spread 

• Unlimited risk if the market rises
• Very difficult to realize the whole profit before maturity
• Relatively high transaction costs due to many “option legs” in the position 

Which strike prices to choose

Which strike prices to choose depends on how many percent you believe a stock or an index will rise and on how risk avert you are. When you establish a positive ratio spread, the higher risk you are willing to take, on the upside, the higher the probability is that the position will reach its maximum return at some point during the contract period. Also, your cost to establish the position will be lower and thereby your potential return on invested capital will be higher. As an example we can compare the position in the above example with creating a positive ratio spread. We do this by buying 10 call option contracts at a strike price of 600 for 20,000 instead, and at the same time write twice as many call option contracts at a strike price of 620 for 10,000 crowns. In this case your maximum profit is 20,000 and your invested capital is zero. Now, only a minor market rise is needed for you to profit from the position and only a rise up to an index value of 620, corresponding to 3.3 percent for you to reach your maximum profit. On the other hand, the probability that the index will rise above your upper strike price of 620 is now higher, and at an index value above 640 your profit will turn into a loss, unless you have not taken any of the above protective actions.