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Ratio writing is a complex discipline that’s more suited to intermediate investors than beginners. That said, a good education in the concepts, goals and execution of ratio-write trades will go a long way toward helping you add this very versatile tool to your options trading toolkit.
For those looking for a brief, clear introduction to this somewhat arcane aspect of options trading, I encourage you to look at this introduction to ratio writing.
In this article, we examine the bear ratio spread. It’s a strategy employed when:
- Traders expect a security to fall; and
- They have a relatively secure notion of the limits of that fall and the time frame in which it will occur.
How Is it Composed?
Bear ratio spreads, like all ratio-write strategies, are made up of two distinct legs. The first is the purchase of an at-the-money put; the second is the sale of two or more out-of-the-money puts. The exact number of puts sold and the strikes selected will determine whether an initial debit or credit is secured on the trade. It will also determine break-even levels and the speed at which either gains or losses are produced.
Let’s have a look at a real-life example to help better understand the strategy.
Below is a chart of aerospace-defense giant Northrop Grumman (NYSE: NOC), a company that has been behaving pleasantly bullishly for some time, though recently you perceived it might be due for a break.
In late July, Northrop jumps nearly 10% in two trading sessions (in red), a move you perceive as wildly exaggerated. Several of your indicators flash “overbought,” and your instincts, too, bellow that the rise is baseless and that big money investors are about to take profits.
Under the circumstances, you decide that the best trade is a bear ratio spread, underpinned at 160, the point at which the rising 200-day moving average will likely be situated at month’s end (blue line).
Trade Details
On the second trading session of August (red circle), you purchase one at-the-money NOC August 172 put for $2.00 and sell two out-of-the-money August 160 puts for $0.25 each, for a total debit of $1.50. (Option strikes appear in black boxes.)
And then it happens.
Northrop falls out of bed mid-month and lands in a heap at exactly $160 at expiry (blue circle).
You couldn’t have dreamed of a better outcome, as the maximum profit on the trade is realized.
Your long put is in the money $12 ($172 – $160) and your two short puts (strike 160) expire worthless. Your profit is a very fine $1,050 ([$12 – $1.50] x 100).
Trading Notes
Remember that the above is for educational purposes only and that traders may or may not choose to employ the same ratios we’ve chosen – nor do they necessiarily have to purchase at-the-money options for their long legs or very distant strikes for their short legs.
The experienced ratio-write strategist recognizes the unique dynamism of the underlying security and sets his trade with strikes, ratios and expiries that best suit his understanding of the risks and rewards inherent in each trade.
You won’t find this anywhere else
You’ll never read about this powerful trading strategy in the Wall Street Journal. Or see it discussed on CNBC. 99 out of 100 brokers know nothing about it. Yet this nearly risk-free trading system has been able to turn $330 into $3,300. And it’s been put together by one man who wants to share its secrets with you. Discover them right here.