A put ratio spread is an advanced option trade and generally not suitable for beginners, but it can have its place within an option portfolio.
It is generally considered a neutral strategy, although it has the ability to make a profit in up, down and sideways markets.
Yes, it can make money no matter which way the market goes, the key is the timing!
The strategy involves buying a number of put options and selling more put options further out-of-the-money.
The trade is placed when the trader thinks the underlying stock will be stable or slowly move lower and finish around the short put strike at expiry.
A fall in implied volatility will benefit the trade and it can also be profitable if the stock moves up early in the trade.
The big risk with the trade is a sharp move lower early in the trade.
Let’s look at an example using Tesla (TSLA).
Tesla Ratio Spread Example
Buying the January 16 put with a strike price of $430 for around $6.55 and selling 2 of the January 16, 420-strike puts for around $4.45 would create a put ratio spread.
As we are selling 2 contracts at $4.45 the trade results in a net credit of $2.35 which is $235 premium.
This is the maximum gain above a stock price of $430. Basically, all the puts would expire worthless and the trader keeps the $235 premium.
A tent-shaped profit zone exists between $410 and $430 with the maximum gain occurring at $420 and is around $1,250.
This is what the trade looks like as of today:
You can see the main risk in the trade is a drop in price early on. The blue line is the profit and loss at expiration and the purple line is the T+0 line. T+0 just means “today”.
So, we don’t want the stock to get into the profit tent too early.
What about in ten days’ time? How does the trade look then?
Looking a lot better for any price above $430.
One advantage of this trade type is it takes advantage of option skew. Notice the contract we are buying has lower volatility (43.86%) than the contract we are selling (42.70%). Buy low, sell high.
Not that the trade starts with a delta of 10, which means the initial position is roughly equivalent to being long 10 shares of TSLA stock, although this will change as the trade progresses.
Company Details
Tesla designs, develops, manufactures, sells and leases high-performance fully electric vehicles and energy generation and storage systems, and offer services related to their products.
They generally sell their products directly to customers and continue to grow their customer-facing infrastructure through a global network of vehicle showrooms and service centers, Mobile Service, body shops, Supercharger stations and Destination Chargers.
The Barchart Technical Opinion rating is an 88% Buy with a Weakening short term outlook on maintaining the current direction.
Long term indicators fully support a continuation of the trend.
Relative Strength just crossed below 50%. The market is indicating support for a bearish trend.
Summary
This strategy should move fairly slowly, unless there is a sharp drop in the stock price.
As the trade involves naked options, it is not recommended for beginners.
You can do this on other stocks as well, but remember to start small until you understand a bit more about how this all works.
Mitigating Risk
With any option trade, it’s important to have a plan in place on how you will manage the trade if it moves against you.
A stop loss of $400 might make sense in this scenario. If Tesla is below $420 near expiry, there will be assignment risk.
If you have questions on this strategy, please let me know.
Please remember that options are risky, and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
On the date of publication, Gavin McMaster did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
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