##### Construction

In order to construct a put ratio spread we must buy a certain quantity of ITM puts (they can also be ATM or OTM) and write more OTM puts, with the same expiration date on the same underline security. The spread should produce a net credit (the money received from the short puts should be more than the money paid for the long puts).

If for example we buy 1 ITM put and write 2 OTM puts with lower strike then we have a ratio of 1:2. It is an extension of the put bear spread strategy but with more OTM than ITM puts.

##### When to use

When we believe that the price of the underline security will decline but not below the OTM strikes of the short puts, without simultaneously lose our potential to profit from an upward movement of the price or no movement at all. So by applying a put ratio spread we can be profitable irrelevantly of direction as long as the price of the underline at expiration is not far beyond the strike of the OTM puts (below the break-even point).

Suppose that we are long 1 ITM put with strike $25 and premium $1 and short 2 OTM puts with strike $23 and premium $0.75. The net premium received for the opening of the position is $50 [($0.75×200)-($1×100)].

If the stock price at expiration is above the higher strike i.e. $28, all the puts are worthless and we have a profit equal to the net premium received ($50), without estimating commissions.

If the stock price at expiration is within the two strikes ($23 and $25), then again we are profitable. In that case our profit will be different depending on where the price of the underline will be at expiration. If it is exactly at the higher strike ($25) then we achieve a profit equal to the net premium received ($50) because all options are expiring worthless. If it is at the lower strike ($23) then the 2 short puts are expiring worthless and we can exercise the long put. The profit in this case is equal to $250 {[($25-$23)x100]+$50}, which is the maximum possible. Any price in between the two strikes produces profits from $50 to $250.

If the stock at expiration is far below the lower strike, then we have a loss. The profit from the long put will counter-weight the loss from one short put but the second will remain without match and it can produce great losses as long as the stock keeps on falling. In that sense, the higher the ratio, the more risky the strategy becomes, because a higher number of short puts will not be counter-weighted from long puts, hence the loss can be greater.

##### Loss/Profit at expiration

Maximum loss: Very high (until the stock goes to zero) – net premium received + commissions.

Maximum profit: (Higher strike – Lower strike) + net premium received – commissions.

##### Profit/Loss diagram

Below we can see the profit/loss diagram of the put ratio spread strategy. The long put has strike $25 and premium $1 and the 2 written puts have strike $23 and premium $0.75.

##### Put ratio spread strategy example

In the daily chart of stock C, we are at point A and we notice that the price is approaching a strong support (line 1) for the first time and in the context of an up-trending market. So, our expectation is that it will continue down-trending until it hits the support at $25, where it will stop and maybe stay near it for the next 2-3 weeks. We are also unsure about the potential of a sideways or even upward move. In order to include all three possibilities in a trading strategy (mildly down, sideways, up) we can apply a put ratio spread by being long 1 put strike $28 and premium $1.50 and short 3 puts strike $25 and premium $0.75. They will all expire after about three weeks.

The net premium received for opening the position is $75 [($0.75×300)-($1.50×100)].

If the stock price at expiration is above $28 then all puts are worthless and we have the net credit received as profit ($75), minus commissions.

If the stock at expiration is between the strikes ($25 and $28), our profit is augmented by the amount that the long put is ITM (intrinsic value). For example if the stock price at expiration is at $26, then the 3 short options are worthless and the long put produces a profit of $200 [($28-$26)x100], plus the net credit ($275 total). At $25 (lower strike) we achieve the maximum profit which is equal to $375 {[($28-$25)x100]+$75}, minus commissions.

We are starting having losses if the stock price at expiration is below the break-even point of $23.75 [lower strike-(maximum profit/3)]. In this case the 1 short put is counter-balanced from the 1 long put but the other 2 short puts can produce a great loss (until the stock price goes to zero). That’s why a trader must be alert to close the position if the price starts moving against him/her.

Notice that we can close the whole position or any leg suits us at any time before expiration.