Bearish Ratio Put Spread - A Complete Guide

What is a Ratio Spread?

They use a ratio spread strategy whenever traders believe that an asset won’t show much shift in price shortly. They can be bullish or bearish based on what type of ratio spread the trade utilises.

A little bearish trader uses a ratio put spread, while those who are a little bullish would use a call spread. This ratio is generally two shorts for one long option though traders can always change the balance to suit their objectives.

A ratio put spread involves buying one ATM (at the money) or OTM (out of the money) put option while writing two options that are further out of the money. The difference between the short and long strike prices decides the maximum profit the trade gives and adds any credit if received.

Bearish Ratio Put Spread Strategy – What does the Term Mean?

This is a multi-leg, limited profit, neutral options strategy that aims to benefit from a fall in the price of an asset. It is much like an advanced bear put strategy but is more complicated and flexible.

It is different from the bear put spread in that you don’t have to keep the number of options the same for buy and sell; you can sell a higher amount depending on your objectives.

Why Use Bear Ratio Put Spread Strategy?

This is one options strategy that offers flexibility in using them. The primary purpose of the bear ratio spread is to earn a profit from an asset’s price decline as per your expectations.

Being flexible about the ratio of writing options and the strikes, this strategy allows for creating a trade in a way that suits you the best.

The strategy can be used to reduce the initial costs associated with speculation about a downward price shift.

You can also use it to profit if there is little to no price shift of the security and profit when it goes down in price. Once you know how it works, it can be used according to your objectives and outlook.

When to Use This Trading Strategy?

The Bear Ratio Put Spread is initiated when the trader thinks the underlying asset will fall in the near future only up to the sold strike.

The strategy is used to minimise upfront costs of premium and can sometimes even get you upfront credit.

Let us take a look at the following premium table for a better understanding of the risks and payoffs of this strategy,

Risk Profile

The strategy encompasses limited profit potential and undefined risk for derivatives traders. You are exposed to an unlimited risk if the underlying asset breaks lower than the strike price of the short put options, and the position can start losing money indefinitely.

With a regular spread trade, the short and long positions are equal, so a big move in the asset’s price does not create a big loss.

However, for a ratio spread strategy, the short positions are twice or more times the long positions. The longs match with only a portion of the short positions, and the rest are left uncovered or naked.

In a bearish ratio put spread, as the trader has sold more than they have long, a bigger loss occurs if the price moves to the downside.

How To Trade To Create a Bearish Ratio Put Spread?

To create a bearish ratio put spread, you need to make two transactions – buy puts and write more puts.

• The strategy is flexible in that you can decide on the strikes you use for the transactions and the options you write relative to what you buy. You can adjust the strikes and the ratio that suit you and try to get the most out of a prediction.
• While there are no strict rules about the ratio or strikes you should use, it is advisable that you keep things as simple as you can until you are well-experienced with the strategy.
• An ideal way to create a ratio put spread is to put options at the money and write options with a lower strike close to the price you expect the asset to fall to.
• The strike used during the write ultimately decides how much profit you make using the strategy and the upfront cost you incur.
• Using a lower strike would let you earn a higher profit, but these contracts are cheaper, and you get less money when you write.
• The amount of the contract will also affect the cost of the spread. The more you write, the more you receive and the lower the price is. You can write a sufficient contract to receive the desired net credit.

Example

Let us try to understand, with an example, how a bear ratio put spread can be established along with the outcomes you can expect in specific scenarios.

Suppose company X stock is currently trading at $100, and you expect the price to fall to about $92. ATM puts on the asset are trading at $4, and OTM puts are trading at $0.4. You are buying one put options contract at a strike price of $100 at $400, which is Leg A.

Also, you write two contracts with a strike price of $92 for a credit of $80, which is Leg B. You have created a bear ratio put spread for a debit of $320.

If the company’s stock does not fall in price or goes up, by expiration, the puts you have written on Leg B will go worthless, and you will have no liabilities. Also, the puts in Leg A will expire worthlessly, and you get no returns. With the strategy, you lose the $320 net debit.

If the stock price falls to $92 at expiration, the Leg B puts will become ATM and be worthless at expiration. However, the ones you have bought will be in the money and worth around $8 each, which means $800.

Deducting your investment of $320, your profit is $480. Now, if the stock price goes down to $84 by expiration, your Leg B puts expire in the money, and the option would be worth $8 each, giving you a total liability of $1600. The Leg A puts will be worth $16 each for $1600. So these values will cancel each other, and your initial investment will be your net loss.

Should the stock fall further in price, your loss keeps increasing. The puts your rise in value, but those written also rise at an equal rate, and you end up incurring bigger losses because you have to double them. You can, however, sell your position at any time to reduce the loss.

Pros and Cons of the Bearish Ratio Put Spread

Upsides

• Results in gains even if the stock price rises
• Higher gains can be achieved than a bear spread upon closing at the strike price.
• Flexible enough to be used the way it suits your objectives the best

Downsides

• Requires margin
• Some brokers may not permit beginners to use the strategy
• It is a complicated strategy that may make it difficult to understand how to use the best and should only be used by experienced traders

Final Thoughts

Derivative traders often jump into options trading without proper knowledge and awareness of the strategies they can benefit from. Bearish Ratio Put Spread is a highly effective strategy that, if completely understood, allows you to achieve your objectives.

However, it is a complex strategy that demands some effort to work out the best strikes and ratio. For this reason, it is not ideal for beginners, but experienced traders should be able to make good returns with the bearish ratio put spread strategy for options.