A put ratio spread is an advanced option trade and generally not suitable for beginners, but it can have its place within an option portfolio.
It is generally considered a neutral strategy, although it has the ability to make a profit in up, down and sideways markets.
Yes, it can make money no matter which way the market goes, the key is the timing!
The strategy involves buying a number of put options and selling more put options further out-of-the-money.
The trade is placed when the trader thinks the underlying stock will be stable or slowly move lower and finish around the short put strike at expiry.
A fall in implied volatility will benefit the trade and it can also be profitable if the stock moves up early in the trade.
The big risk with the trade is a sharp move lower early in the trade.
Let’s look at an example using Amazon (AMZN).
Amazon Ratio Spread Example
Buying the August 21 put with a strike price of $230 for around $7.45 and selling 2 of the August 21, 220-strike puts for around $4.70 would create a put ratio spread.
As we are selling 2 contracts at $4.70 the trade results in a net credit of $1.95 which is $195 premium.
This is the maximum gain above a stock price of $230. Basically, all the puts would expire worthless and the trader keeps the $195 premium.
A tent-shaped profit zone exists between $210 and $230 with the maximum gain occurring at $220 and is around $1,200.
This is what the trade looks like as of today:
You can see the main risk in the trade is a drop in price early on. The blue line is the profit and loss at expiration and the purple line is the T+0 line. T+0 just means “today”.
So, we don’t want the stock to get into the profit tent too early.
What about in one month’s time? How does the trade look then?
Looking a lot better for any price above $220.
One advantage of this trade type is it takes advantage of option skew. Notice the contract we are buying has lower volatility (41.36%) than the contract we are selling (42.25%). Buy low, sell high.
Not that the trade starts with a delta of 12, which means the initial position is roughly equivalent to being long 12 shares of AMZN stock, although this will change as the trade progresses.
Company Details
Amazon.com is one of the largest e-commerce providers, with sprawling operations spreading across the globe. Its online retail business revolves around the Prime program well-supported by the company's massive distribution network.
Further, the Whole Foods Market acquisition helped Amazon establish footprint in physical grocery supermarket space. Amazon also enjoys dominant position in the cloud-computing market, particularly in the Infrastructure as a Service space, thanks to Amazon Web Services, which is one of its high-margin generating businesses.
Amazon has also become a household name with its Alexa powered Echo devices.
Artificial Intelligence backed Alexa is helping the company sell products and services.
The company reports revenue under three broad heads'North America, International and AWS, respectively.
Amazon targets three categories of customers - consumers, sellers and website developers.
The Barchart Technical Opinion rating is a 56% Buy with a Weakening short term outlook on maintaining the current direction.
Long term indicators fully support a continuation of the trend.
Relative Strength just crossed above 50%. The market is indicating support for a bullish trend.
Summary
This strategy should move fairly slowly, unless there is a sharp drop in the stock price.
As the trade involves naked options, it is not recommended for beginners.
You can do this on other stocks as well but remember to start small until you understand a bit more about how this all works.
Mitigating Risk
With any option trade, it’s important to have a plan in place on how you will manage the trade if it moves against you.
A stop loss of $200 might make sense in this scenario. If Amazon is below $220 near expiry, there will be assignment risk.
If you have questions on this strategy, please let me know.
Please remember that options are risky, and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
