ratio back spreads

8/10/2019 Ratio Back Spreads

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Download What is a Spread?

Download: Ratio Spreads and Backspreads

Basics of Spreading: Ratio Spreads and Backspreads

What is a Spread?

Review the links below for detailed information.

Terms and Characterizations: Part 1

Terms & Characterizations: Part 2

Spread Order Execution

Calculating Profit & Loss

Early Assignment Risk

More on Terminology

The Strategies

The spreads discussed in this series, may be categorized with respect to their risk/reward

profiles.

Profit limited & Loss limited

Moderately Bullish Moderately Bearish Neutral

Bull Call Spread X

Bear Call Spread X

Bear Put Spread X

Bull Put Spread X

Long Call Time Spread X

Long Put Time Spread X

Long Call Butterfly X

Long Put Butterfly XIron Butterfly X

Long Call Condor X

Long Put Condor X

Iron Condor X

Profit not limited & Loss limited

Very Bullish Very Bearish Neutral

Long Straddle X

Long Strangle X

Call Backspread X

Put Backspread X

Profit limited & Loss not limited

Neutral to slightly Bullish Neutral to slightly Bearish Neutral

Ratio Call Spread X

Ratio Put Spread X


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Short Straddle X

Short Strangle X

NOTE:For each spread example discussed in this class it is assumed that all transactions are openingones. In other words, an investor would initially have no position, but after making the transactionsdescribed would have the spread position under discussion.

In order to simplify the computations, commissions and other costs have not been included in the

examples used in this course and may be significant. These costs will impact the outcome of all stockand options transactions and must be considered prior to entering into any transactions. Investorsshould consult their tax advisor about any potential tax consequences.

Call Backspreads

General Nature & Characterist ics

A call backspread is made up entirely of call options on the same underlying stock(or index). Its constructed by purchasing two or more calls with one strike priceand selling (writing) fewer calls than purchased with a lower strike price but sameexpiration month. The result is a position comprised of long higher-strike calls andshort lower-strike calls at a ratio of long to short thats greater than 1:1 (2:1, 3:1,

3:2 etc.). It therefore includes extra long call contracts.

Call backspread = buy higher-strike calls + sell fewer lower-strike call(s)

Debit vs. Credit

A call backspread may be established for a net debit, a net credit, or even money. This dependsentirely on the prices of the options chosen, and the ratio of long contracts to short.

Call backspread = debit, credit or even money spread

Example

To establish a call backspread with XYZ options, an investor might buy 2 XYZ June 65 calls for $1.75,and at the same time sell (write) 1 XYZ June 60 call for $3.50. The result is the investor holding an XYZJune 65/60 call backspread at a 2:1 ratio for even money ($3.50 paid vs. 2 x $1.75 received).

XYZ June 65/60 Call Backspread

Action Quoted Price* Tot al Price*

Buy 2 XYZ June 65 calls - $1.75 - $350.00

Sell 1 XYZ June 60 call + $3.50 + $350.00

Even 0 0

*Excluding commissions

XYZ June 65/60 Call Backspread

Long 2 XYZ June 65 calls

Short 1 XYZ June 60 call

Expectation

The call backspread is a bullishstrategy, and/or it is generally used when high volatilityin theunderlying stock (or index) is expected. An investor employing this strategy expects the underlying stockprice (or index level) to close high above the long call strike price at expiration.


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Call backspread: bullish

Motivation for Spreading

Since the investor is bullish on the underlying stock (or index), he is buying call contracts. But, he is alsoselling fewer number of lower-strike calls to finance (at least partially) the cost of those long calls. Andsince he is long more calls than short, he hopes the level of the underlying stock (or index) will increase.

Call backspread: pay for higher-strike calls by selling fewer lower-strike calls

Risk vs. Reward

Maximum Profit

On the upside, the maximum profit for a call backspread is unlimited because there are more (excess)long call contracts than short ones. The more excess calls, the greater the upside profit can be.

Maximum profit = unlimited

Maximum Loss

The maximum loss for a call backspread is limited, and will occur if the underlying stock (or index)closes exactly at the long call strike price at expiration. Under this circumstance, the short calls wouldbe repurchased for their intrinsic value (the difference between the calls strike prices), and the longcalls would expire at-the-money and worthless. The maximum loss amount may be calculated with thefollowing formula:

Maximum loss =(strike price differential x number of short calls) net credit received (or + net debit paid)

(Underlying at long strike at expiration)

Downside Profit/Loss

If the spread was initially established at a net debit, this debit amount paid would be the limited

downside loss. If the spread was initially established at a net credit, this credit amount received wouldbe the limited downside profit. Either of these will be seen if the underlying stock (or index) closes at orbelow the lower, short call strike price at expiration. If the spread was initially established for evenmoney, there is no downside profit or loss.

Downside = loss of debit paid orprofit of credit received(Underlying at/below short strike at expiration)

Break-Even Point

The break-even point (BEP) for a call backspread at expiration will occur on the upside of the long call

strike price. It may be calculated in advance with the following formula:

Break-even point =higher strike price + (points of maximum loss number of excess long calls)


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Profit & Loss Before Expiration

Before expiration, an investor can take a profit or cut a loss by closing out the spread. This involvesselling the long call(s) and buying the short call(s), and these closing trades may be executedsimultaneously in one spread transaction. Profit or loss would simply be the net difference between thedebit initially paid (or credit received) for the spread and the credit received (or debit paid) at its closing.

Effect of Volatility

An increase in volatility generally has a positive effect on a call backspread; a decrease in volatilitygenerally has a negative effect.

Effect of Time Decay

Time decay generally has a negative effect on a call backspread because there are more long callsthan short ones. This is especially the case if the underlying stock (or index) stabilizes around the longstrike price as expiration nears.

Call Backspread - Continued

Example

XYZ June 65/60 Call Backpread

2:1

Long 2 XYZ June 65 calls

Short 1 XYZ June 60 call


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Even money (no credit/debit)

Maximum Profit

On the upside, this 2:1 call backspread has one extra (excess) long call contract. Because of this, thepotential profit is theoretically unlimited.

Maximum profit = unlimited

Maximum Loss

The maximum loss for this call backspread would occur if the underlying stock (or index) closed exactlyat the long call strike price of $65 at expiration. The short 60 call would have an intrinsic value of $5,and the long 65 calls would expire at-the-money and with no value. This loss amount can be calculatedin advance according to the formula given earlier:

Maximum loss =($5.00 strike difference x 1 short call) + 0 credit/debit = $5.00, or $500 total

Downside Profit/LossOn the downside, this call backspread has no profit or loss potential because it was initially establishedfor even money.

Break-Even Point

At expiration, the break-even point for this call backspread would be a closing underlying stock price (orindex level) equal to $65 (higher strike price) + ($5.00 points of maximum profit 1 excess long call) =$70.

BEP = $65 higher strike + ($5.00 maximum loss 1 excess long call) = $70

XYZ June 65/60 Call Backpread 2:1

Even Money (no credit/debit)


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Results at Expiration

XYZ Price

Long 2

65 Calls

Profit/Loss*

Short 1

60 Call

Profit/Loss*

Spread

Profit/Loss*

58 $350 + $350 0

60 $350 + $350 0

62 $350 + $150 $200

64 $350 $50 $40065 $350 $150 $500

66 $150 $250 $400

68 + $250 $450 $200

70 + $650 $650 0

72 + $1050 $850 + $200

74 + $1450 $1050 + $400

76 + $1850 $1250 + $600

78 + $2250 $1450 + $800

80 + $2650 $1650 + $1000


Assignment Risk

Assignment on any Equity option or American-style index option can, by contract terms, occur at anytime before expiration, although this generally occurs when the option is in-the-money.

Equity Options

For an equity call option, early assignment usually occurs under specific circumstances; such as when

underlying shareholders are about to be paid a dividend. Assignment at that time might be expectedwhen the dividend amount is greater than the time value in the calls premium, and notice of assignmentmay be received as late as the ex-dividend date. If a call backspread holder is assigned early on shortcalls, then he may exercise as many long calls and buy shares to fulfill the assignment obligation.

American-Sty le Index Options

If early assignment is received on a short call of a call backspread, the cash settlement procedure forindex options will create a debit in the investors brokerage account equal to the cash settlementamount. This cash amount is determined at the end of the day the long call is exercised by its owner.

After receiving assignment notification, usually the next business day, when the investor exercises hislong call the cash settlement amount credited to his account will be determined at the end of that day.There is a full days market risk if the long option is not sold during the trading day assignment is

received.

Put Backspread


A put backspread is made up entirely of put options on the same underlying stock(or index). Its constructed by purchasing two or more puts with one strike priceand selling (writing) fewer puts than purchased with a higher strike price but sameexpiration month. The result is a position comprised of long lower-strike puts andshort higher-strike puts at a ratio of long to short thats greater than 1:1 (2:1, 3:1,3:2 etc.). It therefore includes extra long put contracts.


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Put backspread = buy lower-strike puts + sell fewer higher-strike put(s)

Debit vs. Credit

A put backspread may be established for a net debit, a net credit, or even money. This dependsentirely on the prices of the options chosen, and the ratio of long contracts to short.

Put backspread = debit, credit or even money spread

Example

To establish a put backspread with XYZ options, an investor might buy 2 XYZ June 55 puts for $2.00,and at the same time sell (write) 1 XYZ June 60 put for $4.00. The result is the investor holding an XYZJune 60/55 put backspread at a 2:1 ratio for even money ($4.00 received vs. 2 x $2.00 paid).

XYZ June 55/60 Put Backspread


Buy 2 XYZ June 55 puts - $2.00 - $400.00

Sell 1 XYZ June 60 put + $4.00 + $400.00

Even 0 0


XYZ June 55/60 Put Backspread

Long 2 XYZ June 55 puts

Short 1 XYZ June 60 put

Expectation

The put backspread is a bearishstrategy, and/or it is generally used when high volatilityin theunderlying stock (or index) is expected. An investor employing this strategy expects the underlying stockprice (or index level) to close well below the long put strike price at expiration.

Put backspread: bearish


Since the investor is bearish on the underlying stock (or index), he is buying put contracts. But, he isalso selling fewer number of higher-strike puts to finance (at least partially) the cost of those long puts.

And since he is long more puts than short, he hopes the level of the underlying stock (or index) willdecrease.

Put backspread: pay for lower-strike puts by selling fewer higher-strike puts

Risk vs. Reward

Maximum Profit

On the downside, the maximum profit for a put backspread is substantial because there are more(excess) long put contracts than short ones. The more excess puts, the greater the downside profit canbe. It is limited only by the underlying stock (or index) declining to no less than zero.

Maximum profit = substantial

Maximum Loss

The maximum loss for a put backspread is limited, and will occur if the underlying stock (or index level)closes exactly at the long put strike price at expiration. Under this circumstance, the short puts would berepurchased for their intrinsic value (the difference between the puts strike prices), and the long puts


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would expire at-the-money and worthless. The maximum loss amount may be calculated with thefollowing formula:

Maximum loss =(strike price differential x number of short puts) net credit received (or + net debit paid)

(Underlying at long strike at expiration)

Upside Profit/Loss

If the spread was initially established at a net debit, this debit amount paid would be the limited upsideloss. If the spread was initially established at a net credit, this credit amount received would be thelimited upside profit. Either of these will be seen if the underlying stock (or index) closes at or above thehigher, short put strike price at expiration. If the spread was initially established for even money, thereis no upside profit or loss.

Upside = loss of debit paid or profit of credit received(Underlying at/above short strike at expiration)

Break-Even Point

The break-even point (BEP) for a put backspread at expiration will occur on the downside of the longput strike price. It may be calculated in advance with the following formula:

Break-even point =lower strike price (points of maximum loss number of excess long puts)


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Before expiration, an investor can take a profit or cut a loss by closing out the spread. This involvesselling the long put(s) and buying the short put(s), and these closing trades may be executedsimultaneously in one spread transaction. Profit or loss would simply be the net difference between thedebit initially paid (or credit received) for the spread and the credit received (or debit paid) at its closing.


An increase in volatility generally has a positive effect on a put backspread; a decrease in volatilitygenerally has a negative effect.


Time decay generally has a negative effect on a put backspread because there are more long puts thanshort ones. This is especially the case if the underlying stock (or index) stabilizes around the long strikeprice as expiration nears.

Put Backspread - Continued

Example

XYZ June 55/60 Put Backpread

2:1

Long 2 XYZ June 55 puts

Short 1 XYZ June 60 put


Maximum Profit

Maximum Profit On the downside, this 2:1 put backspread has one extra (excess) long put contract.Because of this, the potential profit is substantial. It is limited only by the underlying stock (or index)

declining to no less than zero.

Maximum profit = substantial

Maximum Loss

The maximum loss for this put backspread would occur if the underlying stock (or index) closed exactlyat the long put strike price of $55 at expiration. The short 60 put would have an intrinsic value of $5, andthe long 55 puts would expire at-the-money and with no value. This loss amount can be calculated inadvance according to the formula given earlier:

Maximum loss =


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($5.00 strike difference x 1 short put) + 0 (credit/debit) = $5.00, or $500 total

Upside Profit/Loss

On the upside, this put backspread has no profit or loss potential because it was initially established foreven money.

Break-Even PointAt expiration, the break-even point for this put backspread would be a closing underlying stock price (orindex level) equal to $55 (lower strike price) ($5.00 points of maximum loss 1 excess long put) = $50.

BEP = $55 lower strike ($5.00 maximum loss 1 excess long put) = $50

XYZ June 55/60 Put Backpread 2:1



XYZ Price

Long 2

55 Puts

Profit/Loss*

Short 1

60 Put

Profit/Loss*

Spread

Profit/Loss*

40 + $2600 $1600 + $1000

42 + $2200 $1400 + $800

44 + $1800 $1200 + $600

46 + $1400 $1000 + $400

48 + $1000 $800 + $200

50 + $600 $600 0

52 + $200 $400 $200

54 $200 $200 $400

55 $400 $100 $500

56 $400 0 $400

58 $400 + $200 $200


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60 $400 + $400 0

62 $400 + $400 0


Assignment Risk


Equity Options

For an equity put option, early assignment generally occurs when the short put is deep in-the-money,expiration is relatively near, and its premium has little or no time value. If a put backspread holder isassigned early on short puts, then he may exercise as many long puts to sell shares purchased via theassignment obligation.

American-Sty le Index Options

If early assignment is received on short puts of a put backspread, the cash settlement procedure forindex options will create a debit in the investors brokerage account equal to the cash settlement

amount. This cash amount is determined at the end of the day the long put is exercised by its owner.After receiving assignment notification, usually the next business day, when the investor exercises a longput the cash settlement amount credited to his account will be determined at the end of that day. Thereis a full days market risk if the long option is not sold during the trading day assignment is received.

Ratio Call Spread


The ratio call spread is made up entirely of call options on the same underlyingstock (or index). Its constructed by purchasing one or more calls with one strikeprice and selling (writing) more calls than purchased with a higher strike price butsame expiration month. The result is a position comprised of long lower-strike calls

and short higher-strike calls at a ratio of long to short thats less than 1:1 (1:2, 1:3,2:3 etc.). It therefore includes naked (uncovered) short call contracts. Thisstrategy may also be referred to as a call frontspread.

Ratio call spread = buy lower-strike call(s) + sell greater number higher-strike call(s)

Debit vs. Credit

A ratio call spread may be established for a net debit, a net credit, or even money. This dependsentirely on the prices of the options chosen, and the ratio of long contracts to short.

Ratio call spread = debit, credit or even money spread

Example

To establish a ratio call spread with XYZ options, an investor might buy 1 XYZ June 60 call for $3.00,

and at the same time sell (write) 2 XYZ June 65 calls for $1.50. The result is the investor holding anXYZ June 60/65 ratio call spread at a 1:2 ratio for even money ($3.00 paid vs. 2 x $1.50 received).

XYZ June 60/65 Ratio Call Spread


Buy 1 XYZ June 60 call - $3.00 - $300.00

Sell 2 XYZ June 65 calls + $1.50 x 2 + $300.00

Even 0 0


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Long 1 XYZ June 60 call

Short 2 XYZ June 65 calls

Expectation

The ratio call spread is a neutral to slightly bullish strategy, depending on the strike prices in relation tothe price of the underlying stock (or index level) when it is established. Its generally used when lowunderlying stock volatility is expected, because an investor employing this strategy expects theunderlying stock (or index level) to stabilize and close at the short call strike price at expiration. Thisspread can take on a slightly bullish characteristic if the short calls strike price is out-of-the-moneywhen the spread is established.

Ratio call spread: neutral to slightly bullish


Since the investor is neutral on the underlying stock (or index), he expects to profit from the premium

received from writing the short call contracts he anticipates will expire at-the-money and with no value.

Ratio call spread: profit from premium of written calls

Risk vs. Reward

Maximum Profit

The maximum profit for a ratio call spread is limited, and will occur if the underlying stock (or index)closes exactly at the short call strike price at expiration. Under this circumstance, the long call will beworth its intrinsic value (the difference between the calls strike prices) and the short calls will expireat-the-money and worthless. The maximum profit amount may be calculated with the following formula:

Maximum profit =(strike price differential x number of long calls) + net credit received (or net debit paid)

(Underlying at short strike at expiration)

Maximum Loss

On the upside, since more calls are written than purchased the potential loss from the extra, uncoveredshort calls is theoretically unlimited. The more uncovered calls, the greater this loss can be.

Maximum loss = unlimited


If the spread was initially established at a net debit, this debit amount paid would be the limiteddownside loss. If the spread was initially established at a net credit, this credit amount received would

be the limited downside profit. Either of these will be seen if the underlying stock (or index) closes at orbelow the lower, long call strike price at expiration. If the spread was initially established for evenmoney, there is no downside profit or loss.

Downside = loss of debit paid or profit of credit received(Underlying at/below long strike at expiration)

Break-Even Point

The break-even point (BEP) for a ratio call spread at expiration will occur on the upside of the short callstrike price. It may be calculated in advance with the following formula:

Break-even point =


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higher strike price + (points of maximum profit number of uncovered calls)


Before expiration, an investor can take a profit or cut a loss by closing out the spread. This involvesselling the long call(s) and buying the short call(s), and these closing trades may be executedsimultaneously in one spread transaction. Profit or loss would simply be the net difference between thedebit initially paid (or credit received) for the spread and the credit received (or debit paid) at its closing.


A decrease in volatility generally has a positive effect on a ratio call spread; an increase in volatilitygenerally has a negative effect.


Time decay generally has a positive effect on a ratio call spread because there are more short callsthan long ones. This is especially the case if the underlying stock (or index) stabilizes around the shortstrike price as expected.

Ratio Call Spread - Continued

Example


Long 1 XYZ June 60 call

Short 2 XYZ June 65 calls


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Maximum Profit

The maximum profit for this ratio call spread would occur if the underlying stock (or index) closedexactly at the short call strike price of $65 at expiration. The long 60 call would have an intrinsic value of$5, and the short 65 calls would expire at-the-money and with no value. This profit amount can becalculated in advance according to the formula given earlier:

Maximum profit =($5.00 strike difference x 1 long call) + 0 credit/debit = $5.00, or $500 total

Maximum Loss

On the upside, this 1:2 ratio call spread has one uncovered (naked) call contract. Because of this, thepotential loss is theoretically unlimited.

Maximum loss = unlimited


On the downside, this ratio call spread has no profit or loss potential because it was initially establishedfor even money.

Break-Even PointAt expiration, the break-even point for this ratio call spread would be a closing underlying stock price (orindex level) equal to $65 (higher strike price) + ($5.00 points of maximum profit 1 uncovered call) = $70.

BEP = $65 higher strike + ($5.00 maximum profit 1 uncovered call) = $70

XYZ June 60/65 Ratio Call Spread 1:2



XYZ Price

Long 1

60 Call

Profit/Loss*

Short 2

65 Calls

Profit/Loss*

Spread

Profit/Loss*

58 $300 + $300 0


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60 $300 + $300 0

62 $100 + $300 + $200

64 + $100 + $300 + $400

65 + $200 + $300 + $500

66 + $300 + $100 + $400

68 + $500 $300 + $200

70 + $700 $700 0

72 + $900 $1100 $200

74 + $1100 $1500 $400

76 + $1300 $1900 $600

78 + $1500 $2300 $800

80 + $1700 $2700 $1000


Assignment Risk


Equity Options

For an equity call option, early assignment usually occurs under specific circumstances; such as whenunderlying shareholders are about to be paid a dividend. Assignment at that time might be expectedwhen the dividend amount is greater than the time value in the calls premium, and notice of assignmentmay be received as late as the ex-dividend date. If a ratio call spread holder is assigned early on shortcalls, then he may exercise as many long calls and buy shares to fulfill the assignment obligation. Ifassigned on uncovered calls (i.e., more short calls than he is long) then he must either purchaseunderlying shares for delivery to fulfill his assignment obligations, or take a short position in thoseshares.

American-Sty le Index OptionsIf early assignment is received on covered short calls of a ratio call spread, the cash settlementprocedure for index options will create a debit in the investors brokerage account equal to the cashsettlement amount. This cash amount is determined at the end of the day the long call is exercised byits owner. After receiving assignment notification, usually the next business day, when the investorexercises an equal number of long calls the cash settlement amount credited to his account will bedetermined at the end of that day. There is a full days market risk if the long option is not sold duringthe trading day assignment is received.

If assigned on uncovered short calls (i.e., more short calls than he is long), the cash settlementprocedure will create a debit in the investors brokerage account equal to the total cash settlementamount.

Ratio Put Spread


A ratio put spread is made up entirely of put options on the same underlying stock(or index). Its constructed by purchasing one or more puts with one strike price andselling (writing) more puts than purchased with a lower strike price but sameexpiration month. The result is a position comprised of long higher-strike puts andshort lower-strike puts at a ratio of long to short thats less than 1:1 (1:2, 3:1, 2:3etc.). It therefore includes naked (uncovered) short put contracts. This strategy mayalso be referred to as a put frontspread.


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Ratio put spread = buy higher-strike put(s) + sell greater number lower-strike put(s)

Debit vs. Credit

A ratio put spread may be established for a net debit, a net credit, or even money. This dependsentirely on the prices of the options chosen, and the ratio of long contracts to short.

Ratio put spread = debit, credit or even money spread

Example

To establish a ratio put spread with XYZ options, an investor might buy 1 XYZ June 60 put for $4.00,and at the same time sell (write) 2 XYZ June 55 puts for $2.00. The result is the investor holding anXYZ June 60/55 ratio put spread at a 1:2 ratio for even money ($4.00 paid vs. 2 x $2.00 received).

XYZ June 60/55 Ratio Put Spread


Buy 1 XYZ June 60 put $4.00 $400.00

Sell 2 XYZ June 55 puts + $2.00 x 2 + $400.00

Even 0 0



Long 1 XYZ June 60 put

Short 2 XYZ June 55 puts

Expectation

The ratio put spread is a neutral to slightly bearish strategy, depending on the strike prices in relation tothe price of the underlying stock (or index level) when it is established. Its generally used when lowunderlying stock volatility is expected. An investor employing this strategy expects the underlying stock(or index level) to stabilize and close at the short put strike price at expiration. This spread can take ona slightly bearish characteristic if the short puts strike price is out-of-the-money when the spread isestablished.

Ratio put spread: neutral to slightly bearish


Since the investor is neutral on the underlying stock (or index), he expects to profit from the premiumreceived from writing the short put contracts he anticipates will expire at-the-money and with no value.

Ratio put spread: profit from premium of written puts

Risk vs. Reward

Maximum Profit

The maximum profit for a ratio put spread is limited, and will occur if the underlying stock (or index)closes exactly at the short put strike price at expiration. Under this circumstance, the long put will beworth its intrinsic value (the difference between the puts strike prices) and the short puts will expireat-the-money and worthless. The maximum profit amount may be calculated with the following formula:

Maximum profit =(strike price differential x number of long puts) + net credit received (or net debit paid)


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(Underlying at short strike at expiration)

Maximum Downside Loss

On the downside, since more puts are written than purchased the potential loss from the extra,uncovered short puts is substantial, limited only by the underlying stock (or index) declining to no lessthan zero. The more uncovered puts, the greater this loss can be.

Downside maximum loss = substantial

Upside Loss/Profit

If the spread was initially established at a net debit, this debit amount paid would be the limited upsideloss. If the spread was initially established at a net credit, this credit amount received would be thelimited upside profit. Either of these will be seen if the underlying stock (or index) closes at or above thehigher, long put strike price at expiration. If the spread was initially established for even money, there isno upside profit or loss.

Upside = loss of debit paid or profit of credit received (Underlying at/above long strike at expiration)

Break-Even Point

The break-even point (BEP) for a ratio put spread at expiration will occur on the downside of the shortput strike price. It may be calculated in advance with the following formula:

Break-even point =

lower strike price (points of maximum profit number of uncovered puts)



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Before expiration, an investor can take a profit or cut a loss by closing out the spread. This involvesselling the long put(s) and buying the short put(s), and these closing trades may be executedsimultaneously in one spread transaction. Profit or loss would simply be the net difference between thedebit initially paid (or credit received) for the spread and the credit received (or debit paid) at its closing.


A decrease in volatility generally has a positive effect on a ratio put spread; an increase in volatilitygenerally has a negative effect.


Time decay generally has a positive effect on a ratio put spread because there are more short putsthan long ones. This is especially the case if the underlying stock (or index) stabilizes around the shortstrike price as expected.

Ratio Put Spread - Continued

Example


1:2

Long 1 XYZ June 60 put

Short 2 XYZ June 55 puts


Maximum Profit

The maximum profit for this ratio put spread would occur if the underlying stock (or index) closed exactlyat the short put strike price of $55 at expiration. The long 60 put would have an intrinsic value of $5, andthe short 55 puts would expire at-the-money and with no value. This profit amount can be calculated inadvance according to the formula given earlier:

Maximum profit =($5.00 strike difference x 1 long put) + 0 (credit/debit) = $5.00, or $500 total

Maximum Loss

On the downside, this 1:2 ratio put spread has one uncovered (naked) put contract. Because of this, thepotential loss is substantial, limited only by the underlying stock (or index) declining to no less than zero.

Maximum loss = substantial

Upside Profit/Loss

On the upside, this ratio put spread has no profit or loss potential because it was initially established foreven money.

Break-Even Point

At expiration, the break-even point for this ratio put spread would be a closing underlying stock price (orindex level) equal to $55 (lower strike price) ($5.00 points of maximum profit 1 uncovered put) = $50.

BEP = $55 lower strike ($5.00 maximum profit 1 uncovered put) = $50


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XYZ June 60/55 Ratio Put Spread 1:2



XYZ PriceLong 160 Put

Profit/Loss*

Short 255 Puts

Profit/Loss*

Spread

Profit/Loss*

40 + $1600 $2600 $1000

42 + $1400 $2200 $800

44 + $1200 $1800 $600

46 + $1000 $1400 $400

48 + $800 $1000 $200

50 + $600 $600 0

52 + $400 $200 + $200

54 + $200 + $200 + $40055 + $100 + $400 + $500

56 0 + $400 + $400

58 $200 + $400 + $200

60 $400 + $400 0

62 $400 + $400 0


Assignment Risk


Equity Options

For an equity put option, early assignment generally occurs when the short put is deep in-the-money,expiration is relatively near, and its premium has little or no time value. If a ratio put spread holder isassigned early on short puts, then he may exercise as many long puts and to sell shares purchased viathe assignment obligation. If assigned on uncovered puts (i.e., more short puts than he is long) then hemust purchase underlying shares.

American-Sty le Index Options If early assignment is received on covered short puts of a ratio putspread, the cash settlement procedure for index options will create a debit in the investors brokerage


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account equal to the cash settlement amount. This cash amount is determined at the end of the day thelong put is exercised by its owner. After receiving assignment notification, usually the next business day,when the investor exercises an equal number of long puts the cash settlement amount credited to hisaccount will be determined at the end of that day. There is a full days market risk if the long option isnot sold during the trading day assignment is received.

If assigned on uncovered short puts (i.e., more short puts than he is long), the cash settlementprocedure will create a debit in the investors brokerage account equal to the total cash settlementamount.

ratio back spreads

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