To apply ratio spreads to manage risk in options, you need to buy a certain number of options and sell more options of the same type at a different strike price. It helps in earning a profit when the stock moves in a certain range, and controls your losses if the move is unexpected. Ratio spreads are mainly used to protect your portfolio with low cost and to earn from time decay.

What Is a Ratio Spread in Options Trading?

A ratio spread is an options strategy where you buy a certain number of options and sell a higher number of options at a different strike price. It is called "ratio" because the number of options bought and sold is not equal. This strategy helps in managing risk and earning profit if the stock moves within a specific price range.

How Does a Ratio Spread Help Manage Risk?

Ratio spreads help manage risk by limiting the amount you spend on buying options because you earn premium by selling extra options. If the stock stays around the strike prices selected, you make a good profit. Even if the stock moves unexpectedly, your losses are controlled compared to simple buying or selling of options alone.

What Are the Types of Ratio Spreads?

The two common types of ratio spreads are Call Ratio Spread and Put Ratio Spread. In a Call Ratio Spread, you buy call options and sell more call options at a higher strike. In a Put Ratio Spread, you buy put options and sell more put options at a lower strike. Both help in earning premium and protecting against sudden big moves in the market.

When Should You Use a Ratio Spread?

You should use a ratio spread when you expect limited movement in the stock price. It is best when you think the stock will stay within a range. It is also useful when you want to earn extra income from options premium but with limited risk compared to selling options naked (without buying protection).

How to Create a Ratio Spread Step-by-Step?

To create a ratio spread, first choose whether you want to use calls or puts. Buy one call (or put) option at a lower strike price. Then sell two (or more) call (or put) options at a higher (or lower) strike price. Make sure the expiry date for both is the same. Select strike prices based on where you expect the stock to move. Always check the net premium you are receiving or paying to control risk better.

What Are the Risks and Rewards of Using Ratio Spreads?

The reward in ratio spreads comes from the premium received by selling more options. You earn if the stock stays near your chosen strikes. But the risk increases if the stock makes a very big move beyond the sold strike prices because you have sold extra options. Therefore, proper planning and strike selection is very important to limit risk and maximize profit.