The world of options trading is very large, with many strategies for profiting, hedging, and acquiring assets cheaply, one of such being a put ratio spread. This will be one of your stronger mechanisms to help you navigate market volatility while also positioning for acquiring shares on the cheap. I will guide you through the put ratio spread strategy step by step in this finite manual, ensuring you understand perfectly how to implement it in your trading arsenal.
In the fast pace of trading, many investors miss out on stocks at the very best buying opportunity. Can you imagine having identified a great stock, then looking on as the price just takes off? You continue to read more about this stock and learn its name but watch in frustration as it continues moving higher because the risk of entering at this elevated level becomes more tedious.
The fear of buying at the top makes one wait for a pullback and often never gets it. Here again, that is a dilemma: wanting to own the stock but feeling that the price is too steep to justify the risk.
Enter the put ratio spread—a solution that allows traders to benefit from potential pullbacks while also setting the stage to acquire shares at a more favorable price. This options strategy is particularly useful when you expect a stock to experience some downward movement but believe that its long-term prospects remain strong.
Using the put ratio spread, you can profit from declines in the short run without worrying about perfect timing in hopes of buying at a lower price.
The Put Ratio Spread is structured to purchase one put option while selling two put options at a lower strike price, all with the same expiration. This naturally creates a net credit or sometimes a small debit that may end up helping to limit potential losses or even offering an income stream. Let’s break down the steps to execute a put ratio spread effectively.
5 Step Strategies for Trading Put Ratio Spreads
Step 1: How to Choose Your Underlying Asset
Before we dive into the strategy, pick a stock that you think is fundamentally sound but currently overbought or ripe for a short-term decline. In this example, we will consider Tesla—a high-volatility stock that many traders have on their radar.
Step 2: Determine the Strike Prices
In other words, before you can implement a put ratio spread, you will first have to choose which strike prices you will buy and sell the puts at. You’ll buy the put option of the higher strike price and you’ll sell two put options of the lower strike price.
Buy Put Option: Start by purchasing one put option, nearest in strike price to the stock’s present market price. Given our example on Tesla, let’s assume Tesla is trading presently at $260 per share. You purchase a put of Tesla expiring in 45 days with a strike of $250.
Sell Two Put Options: This strategy sells two put options at a lower strike price, for an amount just slightly more than one-half the amount you paid for the put you bought. In the example, sell two Tesla 235 May puts that also have an expiration date of May 19, 2023.
Step 3: Determine the Net Credit or Debit
Such a combination realizes a particular net credit to your account. After putting on the trades, you will be paying a small net debit or receiving a simple credit in case the options involve premiums. Taking our Tesla example, if the 250 put option costs $10 a share, each of the 235 puts would bring in $5 a share.
Since you’re selling two 235 puts, the total premium collected is $10, which offsets the cost of buying the 250 put. This results in a net credit of $0, or essentially no out-of-pocket cost.
Step 4: Analyze Potential Outcomes
The beauty of the put ratio spread lies in its flexibility. There are several possible outcomes, depending on how the stock behaves:
- Stock Rises or Stays Flat: If the Tesla stock price is above $250 at expiration, all the options expire worthless, and you keep the initial net credit (if any). You don’t assume a long stock position and instead make a profit from the premium you collected.
- Stock Drops Moderately: For Tesla stock between $235 and $250, the put that you bought will see an increase in value and the two puts you sold will be out of the money and begin to decrease in value as to what you sold it for. The trick here is that there are two you sold, so your profit is not without limit. The maximum profit is made at expiration of stock at strike price of the sold puts, i.e., at $235.
- Stock Drops Significantly: Should Tesla’s stock drop below $235, the assignment will occur at $235. You are, in effect, buying Tesla’s shares at a discount to the market price of $260 that prevailed on the day of trade entry. The downside is that the decline in the stock’s value offsets the profit from the options trade, but you still end up with the shares at a lower price than if you’d bought them in the first place.
Step 5: Managing the Trade
Once the put ratio spread has been put on, it is a matter of monitoring the trade as the expiration approaches. If the stock price moves in your favor, you could consider closing the trade for an early profit. On the other hand, if the stock moves against you, you can determine whether to let the options expire or, further out, you can roll the positions to enable the trade to play out.
Example Result with Tesla
Let’s get back to that Tesla example and work through the put ratio spread.
- Initial Setup: On August 1st, 2023, set up a put ratio spread when you buy one Tesla 250 put and sell two Tesla 235 puts all expiring on September 15th, 2023.
- Outcome 1: Tesla Closes Above $250 on September 15th: If Tesla closes the September 15th trading day above $250, then all the options expire at no charge, and you keep your $0.
- Outcome 2: Tesla closes at $240: Your 250 put is in the money, and you bought it back for a profit. The two 235 puts are still out of the money. You pocket the difference between the strike prices minus the net credit.
- Outcome 3: Tesla has dropped to $230: You receive a sign for 200 shares at a price of $235 each, which in effect is an acquisition price for owning Tesla that is lower than the market is at close when you’ve made the trade.
Conclusion
A put ratio spread is a very flexible way of making money with market pullbacks as well as positioning oneself to acquire shares in a downward movement. This being the case, it is easy for a stay-in-the-trade strategy to be marked by confidence while moving through each daily market turn when dealing with whether it is a high-velocity stock such as Tesla or any other asset.
The careful selection of the strike prices and keeping a keen eye on the trade should award you, one way or another, either profits in options or on equity, albeit at a more attractive price for that stock.
This step-by-step guide likely created a knowledge base with the ability to move forward and execute put ratio spreads effectively in your trading strategy.