While call and put ratio spreads can be effective strategies when you are expecting relatively stable prices over the short term, they are not without risk. By definition, a ratio spread involves more short than long options. If the trade moves against you, the extra short option(s) expose you to unlimited risk.
(You might want to also review a call back spread, which is a ratio spread that involves more long than short options. As such, it is a limited risk, unlimited reward strategy.)
Put Ratio Spread
To create a put ratio spread, you would buy puts at a higher strike and sell a greater number of puts at a lower strike. Ideally, this trade will be initiated for a minimal debit or, if possible, a small credit. This way, if the stock jumps, you won't suffer much because all of the puts will expire worthless. However, if the stock plummets, you have unlimited risk to the downside because you will have sold more options than you bought. For maximum profitability, you want the stock price to stay at the strike price where you are short options.
Using Merrill Lynch (MER), we can create a put ratio spread using in-the-money options. With MER Trading at $39.68 in May, you might sell three of the JUL 40 puts and buy one JUL 50 put.
|MER trading @ $39.68|
|Buy 1 MER JUL 50 Put @ $10.60||$1,060.00|
|Sell 3 MER JUL 40 Put @ $2.40||($720.00)|
*The profit/loss above does not factor in commissions, interest, or tax considerations.
In this case, you would pay a $340 debit for putting on the trade. If the stock jumped above 60, you would only lose the $340 paid for the spread. However, the real money would be made if the stock stayed right around $40. Here, the short 40 puts would expire worthless and the long 50 put would be worth $10. The value of the 50 put, minus the initial $340 debit would bring the net profit up to $660.
A big move to the downside in this case would spell trouble. The downside breakeven point occurs when the stock price equals 36.70, below this point the risk of losses exceeds $7,000.