What is a Ratio Put Spread?
A Ratio Put Spread involves buying a put option and selling two put options at a lower strike price. It profits from moderate stock declines, but can incur large losses if the stock price drops sharply.
- Buy one put option at a higher strike price (e.g., $100).
- Sell two put options at a lower strike price (e.g., $90).
How Payoff Works:
If the stock price falls moderately, you profit. If the stock price drops significantly, your losses can be substantial since you have sold more puts than bought.
Example Payoff Scenarios:
- Stock Price = $95:
- You bought a put at $100, so the value is: 100 - 95 = $5 per share. Total payoff from the bought put = $500 (since one contract covers 100 shares).
- You sold two puts at $90, but the stock price is still above the strike price, so the sold puts expire worthless. No payoff from the sold puts.
- Net Payoff: $500 (bought put) - $0 (net debit) = $500 profit.
- Stock Price = $85:
- The bought put gives a payoff of: 100 - 85 = $15 per share. Total payoff from the bought put = $1,500.
- The sold puts are now in the money: 90 - 85 = $5 per share. Total loss from selling two puts = 2 × 100 × $5 = $1,000.
- Net Payoff: $1,500 (bought put) - $1,000 (sold puts) = $500 profit.
- Stock Price = $75:
- The bought put gives a payoff of: 100 - 75 = $25 per share. Total payoff from the bought put = $2,500.
- The sold puts are deeply in the money: 90 - 75 = $15 per share. Total loss from selling two puts = 2 × 100 × $15 = $3,000.
- Net Payoff: $2,500 (bought put) - $3,000 (sold puts) = -$500 loss.