Understanding ratio spread option strategy

Choosing strikes and expirations

When setting up a ratio spread you must consider the strike price and expiration. If you’re expecting gradual price movement you should choose strike prices that are further apart, whereas if you are expecting rapid movement, you are better off selecting strikes closer together.

There are also factors to consider when choosing an expiration date. Contracts with a near-term expiration give you more exposure to time decay (theta). Meanwhile contracts with a longer-term expiration provide more sensitivity to implied volatility (vega).

Skew, kurtosis, and their impact on ratio spreads

Implied volatility skew

• Steep skew (OTM options more expensive). Selling multiple OTM options can be attractive since premiums are inflated. However, this increases risk if the underlying moves aggressively.
• Flat skew (similar IV across strikes). Less premium advantage for selling multiple options. A trader may prefer a closer strike selection to maximise profits.

Kurtosis (fat tail risks)

A high-kurtosis market means extreme moves are more likely. If you sell multiple options (short ratio spread), you are vulnerable to tail risk. If you buy multiple options (long ratio spread), you can profit significantly from a fat-tail event.

Using ratio spreads with an underlying position

Leveraging a directional view

A trader can use a ratio spread in conjunction with an existing position in the underlying asset.

Example 1: Enhancing a bullish futures position with a ratio call spread

Suppose you own 1 Crude Oil futures contract at USD 100. You establish a 1x2 ratio call spread by:

1. Buying 1 USD 105 call.
2. Selling 2 USD 115 calls.

There are three potential outcomes depending on how the Crude Oil futures price moves. If the market stays below USD 105, your calls expire worthless, but you may make a profit on your long future. If the market rises to USD 115, you will make a profit on your long future and the bull 105-115 call spread. Above USD 115, your gains are capped due to the extra short call. The synthetic position here is akin to a bull call spread plus a covered call. Ideally, this ratio call spread would have been done at zero cost or even earning some premium.

Example 2: Leveraging a short futures position with a ratio put spread

Suppose you are short 1 Gold future at USD 3000. You establish a 1x2 ratio put spread by:

1. Buying 1 USD 2900 put.
2. Selling 2 USD 2700 puts.

If the future declines moderately, your put options provide additional gains. If the future crashes below USD 2700, the gains on your short future will stop at USD 2700 because you are short an additional future. However, if futures move lower down to USD 2700 without going lower, you will have earned more than just your short future because you gained on the put spread. Similar to the ratio call spread and the long future, this position allows you to leverage your underlying view and is ideally done at zero cost or even at a premium.

Pros and cons of ratio spreads

Pros

• Enhanced yield. Collecting premium from multiple short options enhances credit received.
• Strategic leverage. Can provide greater profit potential for a given capital outlay.
• Flexible adjustments. Can be converted into other structures (e.g., butterflies, condors) as the trade evolves.

Cons

• Undefined risk. Some structures expose traders to unlimited loss potential.
• Margin intensive. Selling multiple short options requires higher margin.
• Directional precision required. Works best when the price lands near the short strikes.

The biggest potential negative when using a ratio spread as a directional idea is that the trader can be ‘too correct’. If a trader’s directional call is correct, but the underlying moves above the short calls (below the short puts), they will begin to incur losses even with a correct directional view.

When selling one and buying multiple options, the trader’s view is typically that either nothing happens or a very large move happens. This is often the case around a major market catalyst that many are focused on. Either the news is as expected and is a non-event, or it is a complete surprise and there is a large directional move. The risk is moving right to the strike where the trader is long multiple options and stopping, as this is the max loss on short options and the max pain for time decay.

Ratio spreads may provide flexibility

A ratio spread is like managing inventory—you can sell multiple units to enhance profits, but you must manage risk carefully. Whether you are buying or selling options in a 1:x ratio, this strategy allows traders to express directional views with leveraged exposure. By considering skew, kurtosis, and market conditions, traders can use ratio spreads to maximise returns while carefully managing downside risk. When combined with an underlying position, ratio spreads can provide additional flexibility, allowing traders to fine-tune their risk-reward profile.