Ratio put spread ( Front Spread with Puts)

The Ratio put spread Setup

Assume that GHI Corp is at $150 at the moment. You put on a Ratio Put Spread by buying one put option for $7, one with a 3-month maturity at $150 strike, and selling two puts both with a strike price of $130 for $3 each on the same expiration date.

Who should consider it

This trading strategy is very useful for investors who expect a mild decline in the underlying asset price while they wish to limit losses if their bearish outlook is proved wrong. It is also quite interesting for time value decay trades regarding the sold options.

Strategy explained

In a Ratio Put Spread, you sell more put options than you buy, thus the received premiums from sold puts can be offset against the costs of bought puts, which might reduce the initial cost of the spread or even produce a net credit.

Breakeven Process

Breakeven points for a ratio put spread can become complex due to the differing number of options. Generally, the upper breakeven point is close to the higher strike adjusted by the net premium received or paid. The lower breakeven would be calculated by taking the lower strike, subtracting the difference between the strike prices and the net premium from that lower strike.

Sweet Spot

The sweet spot is the price at expiration when a stock is equal to or just above the lower strike price. This configuration allows for the maximization of profit potential from the spread until the additional sold puts begin to incur even further losses.

Max Profit Potential

A trader ideally employs this strategy when the maximum profit is reached when the stock price equals the strike price of the short put, and the profit will be the difference between the strike prices, minus the net credit from the spread, multiplied by the number of options traded.

Maximum Drawdown

While the maximum loss could potentially be large, it is not theoretically unlimited. It occurs in the event that the stock rises so excessively that theoretical puts are worthless. The potential loss is in the limit of the net premium paid, or lessened by any net credit received at setup.

Risk

While the risk is somewhat limited compared to strategies that involve unlimited potential loss (such as some call spreads), substantial risk arises in the event that the stock price rises significantly above all strike prices since all upside put options become worthless.

Time Decay

Time decay is generally favorable to this strategy, particularly with regard to the sold put options. As expiration approaches, if the stock price stays comfortably above the lower strike price, the short puts can decay faster than the long puts, and thus profitability increases.

Implied Volatility

Any increase in implied volatility could be detrimental to this strategy, at least in the case of long and short positions. However, a reduction in implied volatility is typically favorable once a position is established, as it decreases the likelihood of lower strike short puts gaining in value.

Conclusion

Traders with a moderate bearish outlook and a practical ability to manage their options positions will find Ratio Put Spread an effective tool. The strategy allows traders to profit from directional moves and time decay, striking a smooth balance between risk and reward in unpredictable markets.