An Essential Guide to the Put Ratio Spread (Example and Things to Know)

We often tell you that one of the main advantages of options trading is that you can benefit from little or no movement in the underlying price. A put ratio spread offers this potential by buying and selling puts. This guide tells you the main aspects you should know about this strategy with a put ratio spread example and key aspects of using a ratio put spread.

Key takeaways

• The put ratio spread is an options trading strategy that involves buying and selling different numbers of puts, with potential profit from minimal investment but risks of unlimited losses if not managed properly.
• Ideally, the put ratio spread will capitalize on moderate underlying price changes, which is a good choice if you are neutral to slightly bearish on a stock or ETF.
• You can build the trade to have either limited or no upside risk. In any case, your loss potential if the underlying price declines significantly is always uncapped.

What Is the Put Ratio Spread Option Strategy?

The main thing you should know about the put ratio spread option strategy is its simple structure, where you buy a put option and sell two put options at a lower strike price (note that all options should be out-of-the-money, OTM).

To be clear, you don’t need to respect the 2:1 ratio, as you could be more creative and go for a 3:1, 4:3, 5:4, or whatever you prefer. However, the classic version of this strategy uses a 2:1 ratio, and we will stick to it for the sake of clarity.

This ratio put spread allows traders to leverage market conditions and premium differentials for potential profit. Key components of this strategy include:

• Buying a Put Option: Profit from declining stock prices.
• Selling Two Put Options: At a lower strike, these generate premium income.
• Strike Price Differences: Determines the potential profit and risk.
• Option Expiry: Timing affects the strategy’s success, as options lose value over time. In general, you will pick options with the same expiration date (otherwise, this would turn into a combination of a put ratio spread and a calendar spread).

The main idea of a put ratio spread is to aim to profit from the net premium difference. This strategy can be a good idea when you anticipate limited downside stock movements or when the stock price remains stable. The goal is to maximize gains from the premium while minimizing risks.

This is what the P&L of your typical put ratio spread will look like:

Note that your potential loss is unlimited if the underlying stock price moves below the breakeven level. You have a capped profit as you see, but there’s a peak right where your short strike prices are.

As we will tell you later in the article, this strategy also has its inverse version: the back put ratio spread, while this classic version is normally referred to as “front put ratio spread.” For now, let’s stick to this standard version and go through a real-market put ratio spread example.

A Real-Life Put Ratio Spread Example

A put ratio spread example will probably tell you more than a thousand words. Let’s take a look at IWM, a popular ETF for options trading. If you decide to use a put ratio spread, you will start by buying a $215 put option and selling two $210 puts, both expiring in two months. Here’s how this setup works:

• Long Put Leg: Buy a $215 put option.
• Short Put Legs: Sell two $210 put options.

Note that you could find either one of these legs (the long put or the naked puts) on our options screener. Here is what your P&L would look like:

This configuration allows you to profit if IWM remains above your breakeven price of $202.03 by the expiration date. Ideally, you want IWM to hover around $210 to maximize your profit, potentially reaching $791. What’s great about this approach is that, unlike a naked put, there’s no upside risk. If IWM trades above $215, you’re still securing a capped profit of $295.

This strategy offers a unique profit profile:

• Profit Peak: You have a peak in your profit and loss profile, providing a more favorable outcome than a naked put if the stock remains stable or slightly decreases.
• Potential Losses: While there’s a risk of unlimited losses on the downside, akin to a naked put, the upside is capped, safeguarding you from potential losses if the market trends upward.

The rationale behind choosing a put ratio spread over a naked put is simple. You anticipate that IWM might not experience significant declines, but you want to capitalize on any slight downside movement for enhanced profits. This makes the put ratio spread a versatile strategy, offering a middle ground between risk and reward.

Therefore, this strategy allows you to benefit from market conditions where you expect minimal movement, avoiding the downside exposure of a naked put while maximizing profits with a strategic setup.

You can find your own put ratio spreads on IWM and all the other tickers on our options screener. Just create a new scan and select the “Put Ratio Spread” strategy from the dropdown menu. For instance, if you are bullish on Tesla (TSLA), currently trading at $261.63, you could opt for this strategy:

Note that you have a potentially unlimited loss risk on the left, and a breakeven price of $232.05 (meaning that you want TSLA to close above this price by the time your puts expire). Also, this is a classic 1:2 spread, but, if you are feeling particularly bullish on TSLA, you can play with this ratio on our screener. For instance, this is what you’d get with a 1:3 ratio (with a slightly different strike price for the puts you’d sell and different expiration):

Note that:

• Your potential loss increases (in the 1:2 case, you’d lose a little more above $1,000 with TSLA trading at $220, while the 1:3 trade would result in a loss that is close to $3,000)
• Your breakeven price changes (from $232.05 to $234.63)
• Your maximum profit (from a little more above $3,000 to over $5,000)
• If TSLA goes up significantly, you have no upside risk in both cases, although your return changes (from roughly $300 to over $1,500).

Other Factors to Consider When Opening a Put Ratio Spread

There are also other aspects you should take into account when opening a put ratio spread, as we tell you below. This is a table summarizing the main additional factors to consider when using a put ratio spread:

Underlying Price Change Impact

When you open a put ratio spread, the delta is initially positive, meaning if the stock price declines early on, you may experience a loss. This is because the value of the long put increases more slowly than the loss on the two short puts. However, the maximum profit is achieved if the stock price remains near the strike of the sold puts by expiration. This is why limited movement in the underlying stock is ideal for this strategy—if the stock price hovers around the short strike as expiration approaches, the position can yield maximum profit.

To better understand it, consider a P&L chart like that of the example we mentioned earlier. Over time, as expiration nears, the potential losses from early price declines diminish, moving the green profit line (today) closer to the yellow line (at expiration).

Time Decay Impact

Time decay, or theta, benefits a put ratio spread. As each day passes, the time value of options decreases. This reduction helps lower the value of the two short puts.

Ideally, the underlying stock makes minimal moves, allowing the time value to erode significantly as expiration nears. This decrease might enable you to buy back the short puts for less than you initially received, while the long put maintains its intrinsic value.

Implied Volatility Impact

A decrease in implied volatility benefits put ratio spreads. Lower volatility reduces option premiums, which is advantageous when the spread is initiated at a higher volatility level.

As implied volatility drops, the value of the short puts decreases more quickly. While implied volatility (vega) remains unpredictable, it’s crucial to understand its impact on option pricing.

Adjusting a Put Ratio Spread

You might adjust a put ratio spread before expiration to extend the trade’s duration or change the spread’s ratio. If the underlying security threatens the short puts, purchasing additional long puts can convert the spread to a 1:1 ratio, capping risk.

Adjustments typically cause extra costs in your ratio put spread, raising risk, lowering profit potential, and narrowing break-even points. Given that the spread involves two short contracts, there’s an assignment risk before expiration.

Front vs Back Put Ratio Spread – Profit & Loss Risk (and More)

An essential difference we need to understand between front and back put ratio spreads lies in their construction and purpose. The front put ratio spread is typically neutral to bearish, established for a net credit, minimizing upside risk. Conversely, the back put ratio spread is more bearish, designed for a potential unlimited profit, and involves buying more options than selling, resulting in a net debit.

The table below recaps the main differences between the front and the back put ratio spread:

The Front Put Ratio Spread

A front put ratio spread is a strategic choice for traders anticipating a stable to slightly bearish market. It involves setting up a put debit spread, complemented by adding an additional short put at the same strike as the short leg of the debit spread.

• Structure: Purchase a put debit spread and sell an additional put at the short strike.
• Net Credit: The strategy is typically initiated for a net credit to the trader. You can actually play with the options to have either a credit or a debit position.
• No Upside Risk: Assuming you opened the trade with a net credit, you’ll carry no risk if the underlying asset’s price increases significantly.

This strategy benefits from minimal price movement downwards, as the additional short put helps offset the cost of the spread. The objective is to capture time decay and premium, maximizing profitability if the stock closes near the strike of the short puts.

The Back Put Ratio Spread

The back put ratio spread flips the strategy of its front counterpart. Here, the trader buys more options than they sell, making it a more aggressive stance with increased cost but greater profit potential.

• Structure: Sell one put option and buy two put options further than the money.
• Net Debit: This setup usually results in a net debit. Just like we mentioned for the front case, you can play around with the options to build either a net debit or a net credit position.
• Unlimited Profit Potential: Normally, the strategy is opened with a net debit, because this means that the additional bought options provide a chance for unlimited profits as the stock price declines.

Ultimately, choosing between a front or back put ratio spread depends on market outlook and risk tolerance. Each offers unique advantages and potential outcomes, making them versatile tools in an options trader’s arsenal.