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 Netflix (NFLX).

Netflix Ratio Spread Example

Buying the April 19 put with a strike price of $600 for around $17.60 and selling 2 of the April 19, $570-strike puts for around $9.15 would create a put ratio spread.

The trade is placed for a slight credit of $70 which means there is no risk on the upside.

This would occur above a stock price of $600. Basically, all the puts would expire worthless and the trader keep the $70 premium paid.

A tent-shaped profit zone exists between $540 and $600 with the maximum gain occurring at $570 and is around $3,070

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. The trade starts with delta 7, which means the trade is roughly equivalent to owning 7 shares of NFLX stock. This will change as the trade progress and may switch to negative delta if the stock stays above $600.

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

Looking a lot better for any price above $570.

One advantage of this trade type is it takes advantage of option skew. Notice the contract we are buying has lower volatility (47.36%) than the contract we are selling (48.39%). Buy low, sell high.

Company Details

Netflix is considered a pioneer in the streaming space. The company evolved from a small DVD-rental provider to a dominant streaming service provider, courtesy of its wide-ranging content portfolio and a fortified international footprint. 

Netflix has been spending aggressively on building its original show portfolio. This is helping it sustain its leading position despite the launch of new services like Disney and Apple TV as well as the existing services like Amazon prime video.

Netflix streams movies, television shows and documentaries across a wide variety of genres and languages. Subscribers, both domestic and international, can watch them on a host of internet-connected devices, including television sets, computers and mobile devices. 

In the Domestic DVD segment, Netflix delivers DVDs through the U.S. postal service from distribution centers located in major U.S. cities.

The Barchart Technical Opinion rating is a 100% Buy with a strengthening short term outlook on maintaining the current direction.

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 $500 might make sense in this scenario. If Netflix is below $570 as expiration draws near, there will be assignment risk

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.