The “ratio put spread”!
Here are the steps for creating this options position:
1. Select two put options with the same expiration, but different strike prices. The option with the higher strike price will be more expensive.
2. Divide the more expensive price by the price of the cheaper option. Then round down to get a whole number N.
3. For every higher strike price put that you buy, sell N number of lower strike puts. Ideally, this will get your net premium paid close to $0.
Profit / Loss Analysis:
If, at expiration, the price of the underlying stock is above the higher strike, then all the options expire worthless. If the stock price is between the options, then you have a profit. The maximum profit is at the lower strike.
If the stock price is lower than the lower strike, then you will start losing on the short puts. The break-even on the trade will occur when (lower strike – stock price) = (higher strike – stock price) / N. After this point, the position will start losing money.
Example:
1. Stock XYZ is trading at $55.65 per share. October 55 puts are trading at $1.23 and October 50 puts are trading at 55 cents.
2. 1.23 / 0.55 = 2.236, so the ratio is 2:1.
3. We buy 1 Oct. 55 put for $123 and sell 2 Oct. 50 puts for $110. Our total premium paid is $13.
4. If, at expiration, XYZ is trading at $55 or above, then we lose the $13 we paid.
5. If XYZ ends up between $55 and $50, then we make money on the Oct 55 put and the Oct 50 puts expire worthless. At $50, we make $500 on the put, for a net of $487. This is the maximum profit.
6. (50 – x) = (55 – x) / 2. Solving this for x results in 45. Thus the position breaks even if the stock is trading at $45: We make $1000 on the long put and lose $1000 on the two short puts.
7. If the stock is below $45, we lose more on the short puts then gain on the long put.
I am the author of “Stock Trading Riches – The Simple, But Powerful Formula That Transforms Your Stock Picks Into Money Pumps”, which is available from Amazon.com.
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