How a ratio spread is built
There are two common versions, and both use options with the same expiration.
| Version | Long leg | Short leg | View | Main risk |
|---|---|---|---|---|
| 1x2 call ratio spread | Buy 1 call at a lower strike | Sell 2 calls at a higher strike | Moderate rise, then stall | Unlimited loss on a large rise |
| 1x2 put ratio spread | Buy 1 put at a higher strike | Sell 2 puts at a lower strike | Moderate fall, then stall | Large loss on a large fall |
| Call backspread (reverse) | Buy 2 calls at a higher strike | Sell 1 call at a lower strike | Large rise | Loss near the long strike |
| Put backspread (reverse) | Buy 2 puts at a lower strike | Sell 1 put at a higher strike | Large fall | Loss near the long strike |
Ratios other than 1x2, such as 2x3, exist. The principle is the same: whenever you sell more options than you buy, the extra ones are uncovered.
Example: a 1x2 call ratio spread
At expiration the payoff looks like this:
| Stock at expiration | Long $50 call | Two short $55 calls | Net after $0.60 cost | Per spread |
|---|---|---|---|---|
| $45 | $0 | $0 | -$0.60 | -$60 |
| $50.60 | $0.60 | $0 | $0 | $0 |
| $55 | $5.00 | $0 | $4.40 | $440 |
| $59.40 | $9.40 | -$8.80 | $0 | $0 |
| $65 | $15.00 | -$20.00 | -$5.60 | -$560 |
| $75 | $25.00 | -$40.00 | -$15.60 | -$1,560 |
The trade has two breakevens, $50.60 and $59.40. Between them it makes money, with a peak of $440 at $55. Above $59.40 the loss grows by $100 per spread for every dollar the stock rises, with no cap.
If the trader had been able to open it for a credit instead of a debit, the downside below $50 would show a small gain rather than a small loss. The upside risk would be unchanged.
Why traders use ratio spreads
- Lower cost. Selling a second option pays for most or all of the long option.
- A precise view. The trade pays best if the stock moves to a target and stops, which matches some event views, such as a deal price or a well-telegraphed guidance range.
- Selling expensive volatility. If out-of-the-money options carry high implied volatility, as they often do on one side because of options skew, selling two of them collects that premium.
Ratio spreads around earnings and events
Before a scheduled event, implied volatility rises, and after it, volatility usually falls. A ratio spread is net short options, so it gains from that fall, the effect described in what is IV crush. The problem is the size of the move.
The market's expected move is roughly what the at-the-money straddle prices; our guide on how to estimate an earnings move from options shows the calculation. A ratio spread sold with its short strike near the expected move is a bet that the realized move will be no bigger than that. Events are exactly where moves of two or three times the expected size happen, through a guidance cut, a surprise deal or a ruling.
- If you expect a modest move and falling volatility, a ratio spread fits the view but carries tail risk you must size for.
- If you are unsure of the size of the move, a defined-risk structure such as a butterfly spread gives a similar peak with a capped loss.
- If you expect a large move, a backspread or a long straddle fits better than any ratio spread.
- If your broker will not approve uncovered options, the trade is not available, and a vertical spread is the closest substitute.
Choosing strikes and expiration
Most of the risk in a ratio spread is set when you pick the strikes. A few rules of thumb help frame the choice.
- Short strike near your target. The position earns the most at the short strike, so place it where you expect the stock to settle, such as a likely deal price or the edge of a guidance range.
- Distance between strikes. A wider gap raises the maximum profit and pushes the upper breakeven further out, but the extra short option brings in less premium, so the trade costs more.
- Expiration just after the event. An expiry shortly after the catalyst captures most of the volatility drop. A longer expiry leaves more time for the stock to run through the short strike.
- Liquidity. Wide bid-ask spreads on either leg can erase the small edge a ratio spread offers. Our note on options liquidity covers what to check before trading.
A common adjustment is to buy back one of the short options as the stock approaches the short strike, which turns the position into a plain vertical spread with defined risk. That costs money, and in a gap there may be no chance to do it.
Greeks and position management
A ratio spread's Greeks change sign as the stock moves:
- Delta starts positive for a call ratio spread, falls to zero near the short strike and turns negative above it.
- Gamma is negative near and above the short strike, so the position loses faster the further the stock runs.
- Theta is usually positive, because the trade is net short options.
- Vega is usually negative, so a rise in implied volatility hurts before expiration even if the stock does not move.
Close to expiration with the stock near the short strike, pin risk matters: you may not know until after the close whether the short calls will be assigned.
Where this goes wrong
- Treating the debit as the maximum loss. It is the loss only if the stock finishes below the long strike. The real risk sits on the other side.
- Sizing for the expected case. Position size should be set by the loss in a large move, the approach covered in how to size a position before a binary event.
- Ignoring early assignment. Short American-style calls can be assigned early, especially before an ex-dividend date.
- Forgetting margin. A sharp move raises the margin requirement on the uncovered option, which can force a close at the worst time.
- Holding through a takeover bid. A cash offer can lift the stock far above the short strike in one day.
For how Dombey covers event volatility, including real market moves, see market coverage.
The bottom line
A ratio spread sells more options than it buys, which makes it cheap or even a credit but leaves one leg uncovered. It pays best when the stock moves to the short strike and stops, and it loses steadily past the upper breakeven in a call ratio spread or the lower one in a put ratio spread. Around events, the volatility it sells is rich for a reason. Size it for the large move, not the expected one, or choose a defined-risk structure instead.