Put Ratio Spread Options Trading Strategy | Step-by-Step Execution Process, Payoff Graph, Pros & Cons, Adjustments
What is a Put Ratio Spread Options Trading Strategy?
Put Ratio Spread is a bearish options trading strategy that involves buying and selling different amounts of put options with the same expiration date but different strike prices. This strategy aims to generate profit if the underlying asset’s price drops or stays the same.
How does it work?
A Put Ratio Spread involves selling a higher number of put options at a lower strike price and simultaneously buying a smaller number of put options at a higher strike price. The ratio of the number of put options sold to the number of put options bought is typically 2:1 or 3:1.
For example, let’s assume that the underlying asset is trading at $50, and the expiration date is in one month. A Put Ratio Spread could be created by selling two $45 put options and buying one $50 put option. The premium received from selling the two put options is used to finance the purchase of the single higher strike put option.
Step-by-Step Execution Process:
Here are the steps to execute a Put Ratio Spread options strategy:
- Identify a bearish outlook on the underlying asset.
- Select an expiration date that aligns with your bearish outlook.
- Determine the strike prices of the options you want to trade.
- Sell two put options with a lower strike price.
- Buy one put option with a higher strike price. (Generally ATM put option)
- Calculate the net premium received from the options trade.
- Monitor the trade and manage risk accordingly.
Put Ratio Spread Options Trading Strategy Payoff Graph With Example:
The payoff graph of a Put Ratio Spread is as follows:
When the underlying asset’s price falls below the strike price of the sold put options, the Put Ratio Spread starts to generate profits. The maximum profit is limited and occurs when the underlying asset’s price is at the strike price of the bought put option.
Nifty Current Market Price (CPM): 18203.40
Put Ratio Spread Trading Strategy:
- Buy 1 Lot of Nifty 18200 Put (PE) at Premium 68
- Sell 2 Lots of Nifty 18000 Put (PE) at Premium 20
- Net Premium Paid: [68-(2×20)]*50 = 28*50 = 1400
Max profit = When underlying price = strike price of short put (Here Nifty at 18000)
Max Profit Amount = ([strike 2 – strike 1] – net premium paid) * Lot size
In the above graph max profit = [(18200-18000)-28]*50 = (200-28)*50 = 8,600
Upper Break Even point = Long put strike (-/+) Net premium paid or received
Upper Break Even point = 18200-28 = No profit or loss when Nifty is at 18,172 at the expiry
Lower Break Even point =Short put strike – Difference between Long and Short strikes (-/+) premium received or paid
Lower Break Even point = 18000-228 = No profit or loss when Nifty is at 17,772 at the expiry
Max loss = unlimited below the breakeven point (Here loss keeps increasing as much as Nifty goes below 17,772 at the expiry)
Margin needed to deploy this strategy would be around One Lakh Rupees
Pros And Cons Of Put Ratio Spread Options Trading Strategy:
Pros:
- Profit potential in both bearish and neutral market conditions.
- Limited risk if executed correctly.
- Low capital requirement to open the position.
Cons:
- Potential unlimited loss if the underlying asset price drops significantly.
- Can be difficult to adjust if the underlying asset price moves significantly.
- Limited profit potential if the underlying asset price drops significantly.
Adjustments in Profit and Loss:
If the underlying asset’s price drops significantly, adjustments can be made to the Put Ratio Spread options strategy to limit potential losses.
In Profit:
- Close the position for a profit.
- Adjust the position to a lower strike price to increase potential profits.
In Loss:
- Close the position to limit losses.
- Adjust the position to a higher strike price to reduce potential losses.
Conclusion:
Put Ratio Spread is a bearish options trading strategy that can be used in neutral or bearish market conditions. It involves selling a higher number of put options with a lower strike price and simultaneously buying a smaller number of put options with a higher strike price. The potential profits are limited, but the risk is also limited if executed correctly. The Put Ratio Spread can be adjusted if the underlying asset’s price moves significantly to limit potential losses.
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