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.

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 Tesla (TSLA).

Tesla Ratio Spread Example

Buying the February 21 put with a strike price of $360 for around $10.85 and selling 2 of the February 21, 340-strike puts for around $6.50 would create a put ratio spread.

As we are selling 2 contracts at $6.50 the trade results in a net credit of $2.15 which is $215 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 $320 and $360 with the maximum gain occurring at $340 and is around $1,100.

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 $360.

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 7, which means the initial position is roughly equivalent to being long 7 shares of TSLA stock, although this will change as the trade progresses.

Company Details

Tesla is the market leader in battery-powered electric car sales in the United States, with roughly 70% market share. The company's flagship Model 3 is the best-selling EV model in the United States. Tesla, which has managed to garner the reputation of a gold standard over the years, is now a far bigger entity that what it started off since its IPO in 2010, with its market cap crossing $1 trillion for the first time in October 2021.' The EV king's market capitalization is more than the combined value of legacy automakers including Toyota, Volkswagen, Daimler, General Motors and Ford.Over the years, Tesla has shifted from developing niche products for affluent buyers to making more affordable EVs for the masses. The firm's three-pronged business model approach of direct sales, servicing, and charging its EVs sets it apart from other carmakers. Tesla, which is touted as the clean energy revolutionary automaker, is much more than just a car manufacturer.

The Barchart Technical Opinion rating is an 80% Buy with a Strengthening short term outlook on maintaining the current direction.

Long term indicators fully support a continuation of the trend.

Summary

This strategy should move fairly slowly, unless there is a sharp drop in the stock price. 

As the trade involves naked options, it is not recommended for beginners.

You can do this on other stocks as well, but remember to start small until you understand a bit more about how this all works.

Mitigating Risk

With any option trade, it’s important to have a plan in place on how you will manage the trade if it moves against you.

A stop loss of $400 might make sense in this scenario. If Tesla is below $340 near expiry, there will be assignment risk

If you have questions on this strategy, please let me know.

Please remember that options are risky, and investors can lose 100% of their investment. 

This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.