Options Trading Made Easy: Short Bear Ratio Spread

A short bear ratio spread is an options strategy that should be considered in lieu of a straight put purchase. Both produce strong gains if the underlying security falls, but the ratio spread affords the trader:

1. A muted risk/reward profile – slightly less gains than a regular long put, but less risk, too.
2. Less initial cost for the trade.

Here’s how it works.
First up, the trade is initiated by purchasing multiple at-the-money puts and selling one slightly in-the-money put.  The exact number of puts purchased can vary, of course, depending upon both the qualities of the underlying security and the temperament and goals of the trader. But the goal in this regard is nearly always the same: to write the spread so as to produce no debit on the initiative – or, at least, as little as possible.
Let’s take a look at a real-life example to see how it works.
This is a chart of the PowerShares DB Commodity Index Tracking Fund (NYSEArca: DBC), a reasonable proxy for the entire commodity asset class.

Let’s imagine that after reviewing the performance of commodities in general, and DBC in particular, you come to the opinion that the carnage in the commodities pits is far from over.  You decide to take a short position on DBC in September, after the stock has already slid liberally throughout the summer.  But because you’re not sure of the immediate direction of the stock, you select a strategy that permits you both a margin of error and a minimal upfront cost – a short put ratio spread set to expire in December.
With the stock trading at $15, you sell an in-the-money DBC December $16 put for $1.50 and buy three at-the money December $15 puts for $0.50 each. Your total debit on the trade is nil.
But for the next seven weeks, the trade’s outcome is in question. DBC rolls sideways until early November, trading as high as $15.90 during that period and leaving you wondering if there’s ever going to be a break.
And then it happens.
In a matter of seven trading sessions, the stock craters and plumbs below former support at $14.50. Your hopes grow. Then, in December, the follow-through arrives and a new wave of selling brings the shares to rest at $13.25 by expiry.
Show us the money!
Your profit breakdown looks like this.

• Your short put is in the money for a loss of $275 ([$16 – $13.25] x 100).
• Your three long puts are each in the money $1.75, for a total gain of $525.
• Total profit is therefore $250 on no initial expenditure.

How does that stack up against a straight purchase of three at-the-money puts? Well, the cost of one at-the-money put, we know, is $50, so three would have run you $150. By expiry, they would have offered you the same $175 each in profit ($525), less $150 paid up front, for a total take of $375.
More profits. But more money initially expended.
On the other hand, had the stock moved higher to close at, say, $15.50 by expiry, the ratio spread would have suffered a loss, as the short $16 put would still have been in the money $0.50 (the long puts would have expired worthless), creating a net loss of $50.  But with a straight purchase of three at-the-money puts, the entire initial cost of the trade would have been lost – i.e., $150.
That’s the way it nearly always works: bigger profit potential, bigger loss potential.

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.