A put ratio spread is an advanced option trade and generally not suitable for beginners, but it can have its place within an option portfolio.

It is generally considered a neutral strategy, although it has the ability to make a profit in up, down and sideways markets.

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Yes, it can make money no matter which way the market goes, the key is the timing!

The strategy involves buying a number of put options and selling more put options further out-of-the-money.

The trade is placed when the trader thinks the underlying stock will be stable or slowly move lower and finish around the short put strike at expiry.

A fall in implied volatility will benefit the trade and it can also be profitable if the stock moves up early in the trade.

The big risk with the trade is a sharp move lower early in the trade.

Let’s look at an example using Amazon (AMZN).

Amazon Ratio Spread Example

Buying the July 18 put with a strike price of $200 for around $2.50 and selling 2 of the July 18, 195-strike puts for around $1.70 would create a put ratio spread.

As we are selling 2 contracts at $1.70 the trade results in a net credit of $0.90 which is $90 premium.

This is the maximum gain above a stock price of $360. Basically, all the puts would expire worthless and the trader keeps the $215 premium.

A tent-shaped profit zone exists between $190 and $200 with the maximum gain occurring at $195 and is around $600.

This is what the trade looks like as of today:

You can see the main risk in the trade is a drop in price early on. The blue line is the profit and loss at expiration and the purple line is the T+0 line. T+0 just means “today”.

So, we don’t want the stock to get into the profit tent too early.

What about in three weeks’ time? How does the trade look then?

Looking a lot better for any price above $195.

One advantage of this trade type is it takes advantage of option skew. Notice the contract we are buying has lower volatility (65.16%) than the contract we are selling (64.45%). Buy low, sell high.

Not that the trade starts with a delta of 9, which means the initial position is roughly equivalent to being long 9 shares of AMZN stock, although this will change as the trade progresses.