The ratio spread, whether it be with calls or puts, is a powerful strategy that we possess in our arsenal. A call ratio spread is the combination of a long call spread plus an extra short call, where we effectively double up on the short leg of the long spread. A put ratio spread is the combination of a long put spread plus an extra short put, again doubling up on the short leg of the long spread. The reason why this strategy is so effective is that we typically put a ratio spread on for a credit. By doing this, we completely eliminate our risk to one side.
In other words, if we set up a call ratio spread for a credit, we have no risk to the downside. This is because if the underlying falls in price, then the call options will expire OTM, and you will keep the credit collected. If we set up a put ratio spread for a credit, we have no risk to the upside. This is because if the underlying rises in price, then the put options will expire OTM, and you will keep the credit collected. The risk on this trade is actually in the direction that you want the underlying to move. By having that extra short unit on the back end of your long spread, you are exposed to unlimited risk if that short option goes ITM. Therefore, you want to be right directionally, but you don’t want to be “too” right.
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