Put Ratio Spread Explained

What is Put Ratio Spread?

The Put Ratio Spread is a premium neutral strategy that involves buying options at higher strike and selling more options at lower strike of the same underlying stock.

When to initiate the Put Ratio Spread

The Put Ratio Spread is used when an option trader thinks that the underlying asset will fall moderately in the near term only up to the sold strike. This strategy is basically used to reduce the upfront costs of premium and in some cases upfront credit can also be received.

How to construct the Put Ratio Spread?

• Buy 1 ITM/ATM Put
• Sell 2 OTM Put

The Put Ratio Spread is implemented by buying one In-the-Money (ITM) or At-the-Money (ATM) put option and simultaneously selling two Out-the-Money (OTM) put options of the same underlying asset with the same expiry. Strike price can be customized as per the convenience of the trader.

Strategy	Put Ratio Spread
Market Outlook	Moderately bearish with less volatility
Upper Breakeven	Long put strike (-/+) Net premium paid or received
Lower Breakeven	Short put strike - Difference between Long and Short strikes (-/+) premium received or paid
Risk	Unlimited
Reward	Limited (when underlying price = strike price of short put)
Margin required	Yes

Let’s try to understand with an Example:

NIFTY Current market Price Rs	9300
Buy ATM Put (Strike Price) Rs	9300
Premium Paid (per share) Rs	140
Sell OTM Put (Strike Price) Rs	9200
Premium Received Rs	70
Net Premium Paid/Received Rs	0
Upper BEP	9300
Lower BEP	9100
Lot Size	75

Suppose Nifty is trading at Rs 9300. If Mr. A believes that price will fall to 9200 on expiry, then he can initiate Put Ratio Spread by buying one lot of 9300 put strike price at Rs 140 and simultaneously selling two lot of 9200 put strike price at Rs 70. The net premium paid/received to initiate this trade is zero. Maximum profit from the above example would be Rs 7500 (100*75). It would only occur when the underlying asset expires at 9200. In this case, short put options strike will expire worthless and 9300 strike will have some intrinsic value in it. However, maximum loss would be unlimited if it breaches breakeven point on downside.

For the ease of understanding, we did not take in to account commission charges. Following is the payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry NIFTY closes at	Net Payoff from 9300 Put Bought (Rs)	Net Payoff from 9200 Put Sold (Rs) (2Lots)	Net Payoff (Rs)
8700	460	860	-400
8800	360	660	-300
8900	260	460	-200
9000	160	-260	-100
9100	60	-60	0
9150	10	40	50
9200	-40	140	100
9250	-90	140	50
9300	-140	140	0
9350	-140	140	0
9400	-140	140	0
9450	-140	140	0
9500	-140	140	0

The Payoff Graph:

Impact of Options Greeks:

Delta: If the net premium is received from the Put Ratio Spread, then the Delta would be positive, which means any upside movement will result into marginal profit and any major downside movement will result into huge loss.

If the net premium is paid, then the Delta would be negative, which means any upside movement will result into premium loss, whereas a big downside movement is required to incur huge loss.

Vega: The Put Ratio Spread has a negative Vega. An increase in implied volatility will have a negative impact.

Theta: With the passage of time, Theta will have a positive impact on the strategy because option premium will erode as the expiration dates draws nearer.

Gamma: The Put Ratio Spread has short Gamma position, which means any major downside movement will affect the profitability of the strategy.

How to manage Risk?

The Put Ratio Spread is exposed to unlimited risk if underlying asset breaks lower breakeven hence one should follow strict stop loss to limit losses.

Analysis of Put Ratio Spread:

The Put Ratio Spread is best to use when investor is moderately bearish because investor will make maximum profit only when stock price expires at lower (sold) strike. Although your profits will be none to limited if price rises higher.