Ratio Put Spread

investment

Opinion: Neutral to slightly bearish.

Example:
Short 2 Oct 55 Puts @ 2 3/16
Long 1 Oct 60 Put @ 4 1/4

Description: A Put Ratio Spread is a unique “bearish” strategy. It involves a bearish strategy [Bear Put Spread] along with a bullish strategy [Short Put]. A stock investor who is currently bearish on XYZ could use this strategy to profit from a decline and/or own stock in XYZ at much lower prices.

Strategy Profile: A Ratio Put Spread is a neutral to bearish spread. It involves buying one Put at a higher strike and writing two Puts at a lower strike. This spread involves an uncovered (naked) Put since the investor is short more Puts than he or she is long.

The spread can be used by an investor who is bearish on XYZ at its current price of $60 but is willing to own XYZ if it declines significantly. Ownership occurs if below $55 at expiration (i.e., 55 Puts are assigned). Maximum profit occurs with XYZ at $55.

When to use: Most attractive when XYZ is between the two strike prices (e.g., 55-60). If XYZ is at or below the lower strike (55), spread may not be attractive because XYZ is already too close to point where stock ownership is likely. Alternatively, if XYZ is at or above higher strike (60), spread must often be established for a larger debit.

The expiration month selected has a large impact on whether the spread is established for a debit or a credit. The more time until the options’ expiration, the smaller the cost of the spread.

Profit & Loss Characteristics: The spread has limited upside risk. If the spread is established for a debit, that is the maximum the investor can lose if XYZ is above $60 at expiration. If done for a credit, there is no upside risk.

Because stock ownership is possible, the downside risk can be large if XYZ has a large decline before expiration.

Maximum profit potential = strike price differential x number of long Puts – net total $ debit (or plus net total $ credit).

Break-even Point(s): If a debit spread, upside break-even point is equal to the strike price of the long Put minus the position’s net debit.

Downside break-even point is equal to the lower strike price minus (maximum profit potential / # of naked Puts).

Time Decay: Varies. If XYZ is near the strike price of the two written Puts (55), profits from decay accelerate most rapidly over time. If near strike of long Put, impact is negative.

Volatility: An increase in volatility is a negative for this spread. The impact will depend to a large part on both the amount of time left until expiration and the price of XYZ relative to the two strike prices.

Assignment Risk: In that this spread contains written Puts (one covered and one uncovered), the investor must watch XYZ for possible assignment if XYZ is below the lower strike price as expiration approaches.