Options Education Center
Explore strategies
Learn more
Download workspace
Download
Upgrade options level
Learn more
Trading Big Market Moves with Ratio Back Spreads
What is a ratio back spread?
A ratio back spread is an advanced options strategy that involves selling a smaller number of options at one strike price while buying a larger number of options at a different strike price, all with the same expiration date. This strategy gets its name from the ratio of short to long options, typically 1:2 or 1:3, creating a unique risk-reward profile that can benefit traders in specific market conditions.
Why traders choose ratio back spreads
Traders often turn to ratio back spreads when they anticipate significant market movements but want to limit their risk exposure. This strategy particularly appeals to traders who want to capitalize on rising implied volatility while maintaining a controlled risk profile. The ability to enter the position with minimal cost, or sometimes even a credit, makes it especially attractive when traders have strong directional views but want to manage their capital efficiently.
The strategy tends to work well in markets where technical analysis suggests a breakout from consolidation patterns or when fundamental catalysts might trigger substantial price movements. Events like earnings announcements, FDA approvals in biotech stocks, or major economic developments often create the ideal environment for ratio back spreads.
Benefits of trading ratio back spreads
Ratio back spreads offer several compelling advantages for sophisticated options traders.
Asymmetric risk-reward profile
When properly structured, these spreads can provide substantial profit potential with limited risk.
Low or no-cost entry
The position can often be entered for little to no cost, and in some cases, traders can even receive a small credit, effectively getting paid to enter a position with significant upside potential.
Flexibility in volatile markets
As market volatility increases, the additional long options in the ratio spread can appreciate rapidly, potentially leading to profits. This characteristic makes ratio back spreads particularly valuable during market uncertainty or ahead of known volatile events.
Defined risk
Ratio back spreads have a clear maximum loss, which occurs when the underlying asset price sits between the strike prices at expiration. This predictability allows for precise risk management and position sizing.
Understanding the risks
While ratio back spreads offer attractive benefits, they come with specific risks that traders must understand and manage.
Maximum loss in the “dead zone”
The most significant risk is the potential for maximum loss when the underlying asset price remains between the selected strike prices at expiration. This “dead zone” can result in the loss of premium paid for the extra long options while the short option provides insufficient offset.
Assignment risk
The short option in the spread can be assigned any time before expiration, particularly with American-style options. For example, in a call ratio back spread, if the stock price rises above your short strike price, you might face early assignment, especially if there’s an upcoming dividend payment.
Impact of early assignment
Early assignment can disrupt the spread’s intended risk profile and create unexpected margin requirements or stock positions. While the long options in the spread provide some protection, managing an assignment requires quick action and can result in additional transaction costs. Traders should monitor their positions closely when short options become in-the-money and consider closing or rolling the spread to avoid assignment.
Time decay risk
Time decay presents another challenge, particularly affecting the long options in the position. As expiration approaches, the rate of time decay accelerates, potentially eroding the value of the long options faster than the benefit received from the short option. This time decay risk makes position timing and management crucial for success.
Execution and liquidity risks
Traders also face execution risk, especially in less liquid options markets. Executing multiple legs of the trade at favorable prices can be challenging, and wide bid-ask spreads can impact the strategy’s profitability. Additionally, margin requirements for the short options must be carefully considered, as they can tie up trading capital.
Types of ratio back spreads
Call ratio back spread
A call ratio back spread is typically used when expecting a large upward price movement.
a) Structure
- Sell one call option at a lower strike price.
- Buy two or three call options at a higher strike price.
b) Profit and risk
- Maximum profit: Unlimited on upward price movement and limited to the credit received if the price moves downward.
- Maximum risk: The difference between the strike prices minus the premium collected.
c) Breakeven prices
- Downward breakeven: Strike price of the short call plus the credit received.
- Upward breakeven: Strike price of the short call plus two times the difference between the strike prices, minus the initial credit.
Trade example: Call ratio back spread
Lennar Corporation (LEN) appeared in the RadarScreen® filter on the ratio back spread workspace. The company will release an earnings report in 30 days. The implied volatility is relatively low, and there is a weekly uptrend that should accelerate with a positive earnings report.
We will use the January 17 calls since they will still have over 30 days before expiration after the earnings event, reducing the effect of time decay on the spread.
Breakeven analysis
The two breakeven prices are:
- $166.15: Calculated as the short 165 strike plus the premium received.
- $193.85: Calculated as the short 165 strike plus twice the 15-point spread minus the premium received.
Maximum loss
A maximum loss of $1,385 will occur if the underlying stock is at the long strike of 180 at expiration.
Profit potential before expiration
The trade may not be held until its expiration. If the earnings report results in a significant price movement, the position may be closed for a profit when it has more than 30 days to expire.
Post-earnings breakeven points
Adjusting the plot to the day after the earnings release, the price slices on the risk profile in the trade analysis show that before the time value erodes, the updated breakeven prices are at:
- $149.06 and $182.22.
- These breakeven points require a smaller price movement to profit than if held to expiry.
Trade management
The position can be closed manually or managed with an activation rule. For example, you can attach an exit order that triggers when a certain profit or loss has been achieved. This approach demonstrates how to adapt the trade to market conditions and capitalize on price movement following an anticipated earnings event.
Put ratio back spread
A put ratio back spread is most effective when expecting substantial downward price movement.
a) Structure
- Sell one put option at a higher strike price.
- Buy two or three put options at a lower strike price.
b) Profit and risk
- Maximum profit: Unlimited to zero on downward movement and limited to the credit received on upward movement.
- Maximum risk: the difference between the strikes minus the premium collected.
c) Breakeven prices
- Upward breakeven: The short put’s strike price minus the credit received.
- Downward breakeven: The short put’s strike price minus two times the difference between the strike prices plus the initial credit.
Trade example: Put ratio back spread
Adobe Inc. (ADBE) appeared in the RadarScreen filter on the ratio back spread workspace. The company will release an earnings report in 28 days. The price is in a sideways channel and is nearing an open gap that may cause it to drop due to a lack of buying pressure. There is a chance that the price may fall again from a disappointing earnings report, as it did last quarter.
The put ratio back spread will be created using options that expire in 65 days. This will allow for action in the trade after the earnings release while the options have more than 30 days to expire, reducing the effect of time decay on the long options.
Breakeven analysis
The two breakeven prices are:
- The put ratio spread is opened for a credit, unlike the call ratio back spread example.
- The breakeven prices are calculated as usual, but the maximum risk is the difference in strikes plus the premium paid. This would be realized if the options expired with the underlying at the long strike.
Earnings day adjustment
The risk profile improves when we adjust the plot to the day after the earnings release. Instead of breaking even, if ADBE is at $493.50, the spread theoretically profits $1,183. It’s important to note that this is an estimate, and the real-world results may differ.
Less time decay leads to different break-even prices and profit or loss values. The position should be actively managed and can be exited when sufficient profit is achieved or when nearing the maximum acceptable loss. Attaching a take profit and stop loss order after opening the position can help automate these decisions and enhance risk management.
Position management strategies
Successful ratio back spread trading requires active position management. Before entering the trade, traders should establish clear profit targets and stop-loss levels to maximize potential gains while minimizing risk.
Profit targets
A common approach is to take profits when the position reaches 50-70% of its maximum potential profit, as holding for the last portion of potential profit often exposes the position to unnecessary risk.
Automating exits
A profit target and stop loss order can be placed once the ratio back spread has been entered. An order to exit can be placed and set to trigger by using the activation rule feature. For more information, visit Placing activation rules on options orders in TradeStation’s Options Education Center.
Monitoring implied volatility
Monitoring changes in implied volatility is crucial, as significant changes can affect the position’s profitability even if the underlying asset moves in the anticipated direction.
Rolling positions
Traders should also consider rolling positions when approaching expiration to avoid the accelerated time decay of the long options.
These strategies can enable traders to effectively manage ratio back spreads and optimize their outcomes.
Conclusion
Ratio back spreads offer traders a sophisticated way to express directional views while maintaining defined risk parameters. Success with this strategy requires a thorough understanding of options mechanics, careful attention to market conditions, and disciplined position management. While the strategy presents certain risks, its unique characteristics make it a valuable tool in the right market environment.
This content is for educational and informational purposes only. Any symbols, financial instruments, or trading strategies discussed are for demonstration purposes only and are not research or recommendations. TradeStation companies do not provide legal, tax, or investment advice.
Options trading is not suitable for all investors. Your TradeStation Securities’ account application to trade options will be considered and approved or disapproved based on all relevant factors, including your trading experience. See www.TradeStation.com/DisclosureOptions. Visit www.TradeStation.com/Pricing for full details on the costs and fees associated with options.
Margin trading involves risks, and it is important that you fully understand those risks before trading on margin. The Margin Disclosure Statement outlines many of those risks, including that you can lose more funds than you deposit in your margin account; your brokerage firm can force the sale of securities in your account; your brokerage firm can sell your securities without contacting you; and you are not entitled to an extension of time on a margin call. Review the Margin Disclosure Statement at www.TradeStation.com/DisclosureMargin.
Any examples or illustrations provided are hypothetical in nature and do not reflect results actually achieved and do not account for fees, expenses, or other important considerations. These types of examples are provided to illustrate mathematical principles and not meant to predict or project the performance of a specific investment or investment strategy. Accordingly, this information should not be relied upon when making an investment decision.
ID4090528 D1224
