Put Ratio Spread
Outlook: Moderately bearish -- and confident

The put ratio spread is a variation on the theme of a more traditional bear put spread. Rather than buying one put and selling one put at a lower strike, the trader sells a greater number of puts than are purchased -- most frequently, in a 2:1 ratio. This simultaneously lowers the cost of entry and ups the risk factor on the put ratio spread, making an accurate forecast for the underlying stock that much more critical.

To examine how the put ratio spread works and why you might want to try your hand at it, let's break down an example.

Entering the Trade

You're predicting a modest decline for Stock XYZ over the next few months, but you expect the shares to eventually find a solid floor near long-time support in the $50 neighborhood. To capitalize on this limited pullback, you buy to open one at-the-money 55-strike put option for the ask price of 2.20. Simultaneously, you sell to open two 50-strike put options for the bid price of 0.55 each.

Since you paid 2.20 to buy the long put and collected 1.10 (or 0.55 x 2) on the sale of the short puts, your total net debit is 1.10. Multiplied by 100 shares per contract, you've shelled out $110 to enter the put ratio spread.

Potential Gains

The best-case scenario would be for XYZ to finish exactly at $50 upon expiration. This would reap the biggest possible gain on your long put, while both of the short puts could be left to expire worthless. In this outcome, your maximum potential profit is equivalent to the difference between the two strike prices, less the initial net debit -- or [(55 - 50) - 1.10] = 3.90. Accounting for 100 shares per contract, you could garner a profit of $390 on the trade.

The breakeven points, meanwhile, are equivalent to the long put strike less the net debit -- or 55 - 1.10 = 53.90 -- and the short put strike minus the maximum potential profit -- 50 - 3.90 = 46.10. In other words, you'll begin to accrue losses as soon as XYZ moves above $53.90 or below $46.10 per share.

Potential Losses

Unlike a traditional long put spread, there are two different ways you could lose money on a put ratio spread. If XYZ remains at or above the purchased put strike through expiration, you'll forfeit the entire net debit of 1.10, or $110.

On the other hand, if XYZ sinks below the strike price of your sold puts, losses will begin to accrue quickly. That's because only one of your sold puts is hedged by a long put option, so you're stuck with one naked short put. As referenced above, you can still break even on a pullback equivalent to the sold put strike less your maximum profit on the other leg of the trade, or 50 - 3.90 = 46.10.

The maximum potential loss on a drop to zero by XYZ is equivalent to the strike price of the sold put, plus the net debit -- or 50 + 1.10 = 51.10. After multiplying by 100 shares per contract, that's $5,110 in risk you're assuming on the downside of the trade.

Volatility Impact

Since you've sold more options than you've purchased in a put ratio spread, rising implied volatility has a somewhat negative effect. Higher volatility will increase the value of your purchased put, but it will also boost the value of your two (or more) sold options.

Other Considerations

Depending upon your strike selection, as well as the ratio of puts purchased to puts sold, it may also be possible to initiate the put ratio spread for a net credit. In this case, the potential outcomes shift a bit.

If XYZ remains at or above the purchased put strike through expiration, you may still keep that upfront credit as a gain on the trade. You'll begin to collect additional profits as soon as XYZ moves below the purchased strike, with a maximum possible gain equal to the difference between the two strikes, plus net credit. On a drop down to zero, your maximum loss is equivalent to the strike price of the sold puts, minus the net credit.

Since the put ratio spread involves the sale of at least one naked put, be aware that you'll face a margin requirement with your broker. As a result, this trade is best reserved for more experienced speculators.