The Ratio Spread, is a vertical type spread used in trend-less market periods, it’s a simple strategy. In the case of Call Ratio Spreads it involves the buying of one ITM Call option and the writing  .... read more

Generate income with options

The Ratio Spread, is a vertical type spread used in trend-less market periods, it’s a simple strategy. In the case of Call Ratio Spreads it involves the buying of one ITM Call option and the writing of 2 OTM Call options. Being vertical it means that all options have the same expiry date, are on the same stock, same type (Call/Put) and only differ on strike price.
More specifically the OTM options the trader sells, both have to have the same and higher strike price than the ITM one he buys. It’s simple.
Ratio spreads is a potentially high risk strategy, and may appear like nonsense to use on its own. Traders however combine it together with other option spread strategies and actual stock positions, this is where Ratio Spreads serves as a vital component of really sophisticated option trading strategies.

Consider an example where the trader has found a stock trading at around $42-$43, and has bought a Call option with a strike price of 40 (ITM), and at the same time he has written 2 Call options with a strike price of 45 (OTM).

1. The first breakeven point, (lower) is the strike price of the long , ITM Call plus the net debit/credit the spread costs, in this case zero, so we have a lower breakeven point of $40.
2. The higher breakeven point is the strike price of the written OTM Calls, plus the maximum dollar points that the ITM long Call will make, up until the OTM written Calls become ITM, in this case it’s: 45 the strike price of the 2 OTM written Calls, and 5 dollar points that can be made on the long ITM Call before the OTM written Calls start losing money by becoming ITM, so it’s 40+5= 45.

Another property of this spread, is that, is often done for really no cost, as the premiums collected from the written options offset the premium paid on the long Call.
The trader will start losing money on the Call Ratio Spread if and only if the stock passes the given break even point, in the example shown in this profit/loss curve, is $50. But do you realize that, this can be part of a bigger, more sophisticated strategy where the trader will make even more money if the stock rallies this much.
In the above example, if the stock is at around $42-$43 at expiration time the trader will pocket $200-$250, from a free trade. If the stock is at exactly $43, he will pocket $500, again from a premium-free trade that only had commission costs.
One way of using the Ratio Spreads option strategy is to combine it with another strategy that will make a big profit if the stock exceeds the second, higher breakeven point, (in the above example 50) If the trader uses the Ratio Spread in conjunction with a breakout strategy, a strategy that will make a lot of money if the stock breaches an important price level, or just one more complex idea that is only possible to figure out using advanced trade simulation platforms. Then you can imagine that you can really capitalize on the very probability of price action itself!
The key is to identify pivotal points on the charts, as well as being ready to close the Ratio Spread, at any time. There’s nothing stopping you from doing that, should the stock suddenly breach the key level and skyrocket. Technically, it’s a good idea to use the Ratio Spread on stocks that have developed a recent value area, a price zone of heavy volume and congestion. We know that during a 60-90 day period such stocks will either rally as we expect, with the rest of the market, or they will temporarily fall. Usually they register short term sharp drops, but 80% of the time of these 80-90 days, they will be trading within this congestion zone.
Finally, this Ratio Spread strategy is used to recover losses from long stocks, ones that were caused by huge price drops, by implementing the strategy right and profiting from small stock price moves. All losses can often be recovered. This is because the Ratio Spread is a small range strategy, most stocks that drop a lot, like in the dot-com crash of 2000-2001. They drop by 60-80% in few months, then, they trade in a tight range for years. Most investors think big profits have to do with big price swings, and that is wrong! The Ratio Spread proves that you make a lot of money from minor price moves.
Analyzetrade.com offers just the tools a trader needs, to figure out, simulate and implement such trading ideas.