Ratio Spreads
Ratio spreads buy and sell different numbers of options at different strikes. Learn front ratios, backspreads, payoffs, uses and the risk of the extra short options.
A ratio spread buys and sells options of the same type and expiration at different strikes, in unequal quantities. The most common forms are the 1:2 front ratio spread, which buys one option and sells two further out of the money, and the backspread, which does the reverse. Ratio spreads let traders target a price zone at low or no cost, or take a cheap bet on a large move, but the unequal quantities create exposures that are easy to underestimate.
Front ratio spread (1 by 2)#
Buy one option closer to the money and sell two further out of the money.
| Feature | 1:2 call front ratio |
|---|---|
| Construction | Buy 1 lower call, sell 2 higher calls |
| Cost | Often small debit, zero or a credit |
| Best outcome | Price finishes at the short strike |
| Risk | Losses above the upper break even have no cap (one extra short call) |
| Greeks | Short gamma and short vega overall |
Backspread (ratio backspread)#
Sell one option closer to the money and buy two further out of the money. It is the mirror image of a front ratio.
| Feature | Call backspread (1 by 2) |
|---|---|
| Construction | Sell 1 lower call, buy 2 higher calls |
| Cost | Often a small credit or debit |
| Best outcome | A large move up |
| Worst outcome | Price finishes at the long strike |
| Greeks | Long gamma and long vega overall |
Put backspreads are used the same way for large downside moves, often as cheap crash protection.
Why traders use ratios#
- Target a price cheaply: front ratios can be opened for little or no cost, betting on a move to a specific level.
- Take advantage of skew: if out of the money options look expensive relative to closer ones, front ratios sell them; if cheap, backspreads buy them. See Skew Trading and Volatility Smile and Skew.
- Cheap tail exposure: backspreads can profit greatly from extreme moves at low or no cost.
Risk in front ratios#
The extra short option means a front ratio becomes a naked short option beyond the upper break even. Large moves, especially gaps on news, can create big losses. Ways to manage this:
- Buy a further out of the money option to cap the risk, turning the trade into a broken wing butterfly. See Butterfly Spread.
- Close or adjust if price approaches the upper break even.
- Avoid events like earnings.
Risk in backspreads#
Backspreads lose most when the price drifts to the long strike and stops there. Time decay works against them as expiry approaches. See Theta.
Greeks of ratio spreads#
Because quantities are unequal, ratio spreads can carry significant net gamma and vega. A front ratio is short both; a backspread is long both. Always check position Greeks and a full payoff diagram before trading. See Managing Portfolio Greeks and Option Payoff Diagrams.
Common mistakes#
- Treating a front ratio as low risk because it costs little.
- Not having a plan for a move through the upper break even.
- Holding backspreads while they decay near the long strike.
Frequently asked questions#
What is a ratio spread?#
An options position that buys and sells different numbers of options at different strikes, such as buying one call and selling two higher strike calls.
What is a backspread?#
A ratio spread that sells fewer options and buys more, such as selling one call and buying two higher strike calls, profiting from large moves.
Are ratio spreads risky?#
Front ratios carry uncapped risk beyond the upper break even because of the extra short option; backspreads have a defined maximum loss near the long strike.
Next, learn the model behind modern option pricing in Black-Scholes Model.
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