Ratio Spread Options Strategy Explained. // backspreads option spread David Moadel
welcome to looking at the markets with
David Modell today we're going to
discuss a rather advanced or at least
intermediate strategy for options
it's called ratio spreads and first
let's discuss the other types of spreads
then we'll get to the ratio spreads now
vertical spreads use different strike
prices but the same expiration date and
the same number of bought and sold
options calendar spreads use different
expiration dates but the same strike
price and the same number of bought and
sold options diagonal spreads are a
combination of the vertical and the
calendar spreads they use different
strike prices like a vertical spread and
different expiration dates like a
calendar spread with the same number of
bought and sold options once again so
for all three of these strategies your
buying and selling the same number of
options what if you bought and sold
different numbers of options then it
would be a ratio spread so ratio spreads
use a different number of bought and
sold options a ratio of two to one is
the most common but other ratios such as
three to two are also possible but we're
gonna stick to the most popular ratio
which is two to one for these examples
today alright so for example let's say
you buy one out of the money Apple put
option expiring December 15th and at the
same time you sell to slightly further
out of the money Apple put options also
expiring December 15th
so same expiration date different strike
prices but the main feature here is that
you're selling more than you're buying
and so that's what makes it a ratio
spread you're selling and buying
different amounts of options so that's
an example of a ratio put spread because
it's puts it would be most likely it
would be a credit spread because you'd
be receiving a payment up front since
the two puts that you sold would
probably have more total value than the
one
put that you bought that's usually the
case so it depends how you set it up but
most likely it would be a credit spread
because you'd probably be selling more
value than you're buying in this example
you'd have a neutral or bullish
directional assumption for Apple stock
and you're hoping that Apple stock
doesn't go down very much because
remember you sold more puts than you
bought and your maximum loss is rather
large
because if Apple stock keeps going down
below the strike price of the two put
options that you had sold your losses
will get bigger and bigger and the fact
that you bought one put option won't
protect you completely because remember
yeah you did buy one put option but you
sold more you sold two of them here's
another example and this time we'll use
calls instead of puts let's say you buy
one at the money Netflix call option
expiring January 8 and at the same time
you sell to slightly out of the money
Netflix call options also expiring
January 8 so again same expiration date
different slightly different strike
prices but the most interesting part of
this is that it's a ratio spread because
you're buying one and you're selling two
calls so that's an example of a ratio
call spread because it's calls this time
instead of puts it would be a credit
spread probably depends how you set it
up but usually this would be a credit
spread because you'd be receiving a
payment upfront since the two calls that
you've sold would probably have more
total value than the one call that you
bought in this example you'd have a
neutral or bearish directional
assumption for Netflix stock and you're
hoping that Netflix stock doesn't go up
very far because again remember you sold
more calls than you bought and in this
case your maximum loss it's not just
very large it's actually undefined which
is a way of saying that it's potentially
limitless losses because
if Netflix stock keeps going up above
the strike price of the two call options
that you would sold your losses will get
bigger and bigger and the fact that you
bought one call option won't protect you
completely and I drew a little chart
here this would be an example of a call
this is a profit and loss chart for a
call ratio credit spread profit and loss
chart alright so here's your profits are
up here your losses are here your
breakeven is here in the middle and
let's say here's a stock price alright
so when the stock price gets bigger and
you know higher and higher sure you
collected a credit okay and you could do
pretty well here especially if the stock
price doesn't go above the the short
strike as they say the price of the two
calls that you sold when starts when the
stock price starts going above the short
strike price here your profit starts to
get lower and lower and then you get to
break-even and if that stock price just
keeps going up and up and up before
expiration now you're losing more and
more money and it could go down and down
and down I put an arrow head there
because it's it's infinite really you
could just lose more and more and more
money even more money than you have in
your account potentially so please be
careful because these types of ratio
credit spreads and sometimes these are
called front spreads by the way because
these types of ratio credit spreads have
such large maximum losses I personally
don't use them very often and I suggest
being very cautious with this type of
option strategy yeah you almost have to
think of it like a naked selling a naked
call or selling a naked put I want you
to think of it that way really because
because the potential losses are so big
all right so that would be a front
spread and I also want to touch upon
back spreads ok there's also something
called a ratio back spray
in which you reverse this strategy by
purchasing more options than you're
buying therefore it's probably going to
be a debit spread instead of a credit
spread I say probably it all depends on
how you set it up there are exceptions
to all these rules so for example if you
sell one out of the money Microsoft call
option expiring February 6 but then you
buy two slightly further out of the
money
Microsoft call options expiring the same
day February 6 this would be a debit
spread since but probably a debit spread
depends how you set it up but yeah this
would probably be a debit spread since
you're paying money up front your
maximum loss is limited so that's good
and your potential profit is unlimited
and that's good but you'll need a big
upward move in Microsoft stock in a
fairly short period of time to make a
big profit with this strategy
yeah because theta or time decay would
probably be working against you as it
often does with debit spreads and it's
tough it's tough to make a really decent
profit with this strategy although it is
possible
so in conclusion at least with ratio
back spreads it's an interesting way to
create a debit spread but personally I
tend to prefer vertical calendar or
diagonal spreads now I like vertical
spreads a lot just because of their
simplicity
I'm not against calendar or diagonal
spreads and I'm not against ratio back
spreads either it's a matter of personal
preference and as far as the front
spreads which I discussed earlier you
really have to be careful it's something
that you won't see me using all that
often because of this because that
unlimited or very large maximum loss
potential there all right
so I hope this video was helpful to you
as an introduction to ratio spreads I
know it's sometimes complex but this is
one of the more intermediate to advanced
strategies I have plenty of videos on
more basic strategies for options
trading and I hope you'll check those
out and if you like this video please
give it a thumbs up on YouTube and leave
a comment if you'd like to and please
subscribe to my youtube channel and hit
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the latest updates on my financial
educational videos and if you want more
help if you'd like some help putting
together a trading or investing plan you
can email me anytime my email address is
David Modell at gmail.com thank you so
much for watching and listening I'll
talk to you again soon
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