This Day On The Street
Continue to site
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here

Ratio Spreads Offer a Volatility Play

Striking a Balance

In writing a ratio spread, one wants to take advantage of high implied volatilities.

High-volatility stocks typically have what is called a "vertical skew," meaning the implied volatilities move higher as you go up the strike-price chain. In a normal skew, the lower options with lower strike prices typically have a higher implied volatility. Stocks with vertical skews make it easier to set up a zero-premium ratio spread.

However, ratio spreads should only be used by experienced options traders and written in stocks with which they have a high comfort level, confidence in the trading pattern and in situations in which they're willing to take on some risk. This is because ratio spreads have a fairly high gamma, meaning the position's delta is highly sensitive to the price movement in the underlying security. (The delta shows how much the option will change in price as the underlying asset changes in price. Gamma shows how much the option's delta will change as the underlying asset changes in price.)

Unlike a 1-to-1 spread, in which the directional bias remains constant, a ratio spread position will actually swing from being long to short as the underlying price moves higher.

Furthermore, a ratio spread might involve buying one contract of a specified strike and selling two, three or even four contracts of a higher strike. Keep in mind, the higher the ratio, the steeper the loss line will be once the price passes the higher strike.

The key is to find a balance between reducing your cost and multiplying your risk. The goal is to bring the total cost of the spread close to zero by using options that have the greatest separation between strike prices, but require the lowest ratio.

For example, assume shares of XYZ were trading at $50. An even-money spread consisting of buying one $50 call and selling two $50 calls for even money is more attractive than buying one $45 call and selling three $55 calls for even money.
2 of 3

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Only $9.95
14-Days Free
Dividend Stock Advisor

David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Updates with exact steps to take - BUY, HOLD, SELL
Trifecta Stocks

Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

Product Features:
  • Model Portfolio
  • Intra Day Trade alerts
  • Access to Quant Ratings
Real Money

More than 30 investing pros with skin in the game give you actionable insight and investment ideas.

Product Features:
  • Access to Jim Cramer's daily blog
  • Intraday commentary and news
  • Real-time trading forums
Only $49.95
14-Days Free
14-Days Free
BIIB $293.21 0.00%
VLO $72.94 0.00%
AAPL $117.81 0.00%
FB $105.45 0.00%
GOOG $750.26 0.00%


Chart of I:DJI
DOW 17,798.49 -14.90 -0.08%
S&P 500 2,090.11 +1.24 0.06%
NASDAQ 5,127.5250 +11.3820 0.22%

Free Reports

Top Rated Stocks Top Rated Funds Top Rated ETFs