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 to slightly bullish 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 Disney (DIS).
Disney Ratio Spread Example
Buying the February 16 put with a strike price of 95 for around $4.60 and selling 2 of the February 16, 90-strike puts for around $2.40 would create a put ratio spread.
As we are selling 2 contracts at $2.40 the trade results in a net credit of $0.20 which is $20 premium.
This is the maximum gain above a stock price of 95. Basically, all the puts would expire worthless and the trader keeps the $20 premium.
A tent-shaped profit zone exists between 85 and 95 with the maximum gain occurring at 90 and is around $520.
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 four weeks’ time? How does the trade look then?
Looking good provided the price stays above $88.
Company Details
Walt Disney Company has assets that span movies, television, publishing and theme parks. In October 2020, Disney reorganized its media and entertainment operations, which had been previously reported in three segments: Media Networks, Studio Entertainment and Direct-to-Consumer & International. From the first quarter of fiscal 2021, Disney began reporting the financial results of the media and entertainment businesses as one segment, Disney Media and Entertainment Distribution (DMED) across three significant lines of businesses: Linear Networks, Direct to- Consumer and Content Sales/Licensing.
The Barchart Technical Opinion rating is a 72% Buy with a Strengthening short term outlook on maintaining the current direction.
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 Disney is below 90 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.
On the date of publication, Gavin McMaster did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
