Volatility Paradox

Overview

The Ratio Spread is the favorite strategy of "Option Nerds." It is a trade where you buy one option and sell two or more options further out of the money.

Commonly referred to as a "1x2" (one-by-two), this strategy is unique because you can often set it up for a Net Credit. This means if the stock goes down, stays flat, or goes up a little bit, you make money.

[!CAUTION] There is a trap. If the stock "moons" (rises very fast), you have UNLIMITED risk. One of your short calls is covered by your long call, but the second one is naked.

The Setup

A 1x2 Call Ratio Spread consists of:

Long Leg: Buy 1 Call at Strike $K_1$ (closer to the money).
Short Leg: Sell 2 Calls at Strike $K_2$ (further out of the money).

Mechanics: The Profit "Peak"

Low To Flat: If the stock stays below $K_1$ , all options expire worthless. If you entered for a credit, you keep that credit.
The Sweet Spot: If the stock ends exactly at $K_2$ , you make the most money possible. Your long call is worth the full width of the spread, and the two short calls are worth zero.
The Danger Zone: If the stock keeps going past $K_2$ , your "naked" short call starts losing money fast.

Payoff and Break-even

Max Profit

The distance between the strikes plus the credit received (or minus the debit paid).

\text{Max Profit} = (K_2 - K_1) + \text{Credit}

Max Loss

Unlimited to the upside.

Upper Break-even

This is the "Red Line" you must watch:

\text{Upper BE} = K_2 + \text{Max Profit}

The "Flipping" Greeks

Greeks in a Ratio Spread are non-linear, meaning they change personality based on where the stock is.

1. Delta: Positive, then Negative

Near the money, you have a positive Delta (you want the stock to go up). But as the stock passes $K_2$ , your Delta flips negative. You are now effectively short 100 shares of stock for every extra call you sold.

2. Gamma: Short Gamma Peak

Ratio spreads have significant Negative Gamma at the short strike. This means as the stock approaches $K_2$ , your losses will accelerate.

3. Vega: Short Volatility

Because you've sold more options than you've bought, you are "Short Vega." You want the market to stay quiet. A volatility spike will hurt this position.

When to Use?

Implied Volatility Skew: When the further-out calls are overpriced compared to the closer ones.
Targeted Buying: Some traders use Put Ratio Spreads as a way to "get paid to buy stock" at a lower price.

Checklist for Entry

Is the stock unlikely to "gap up" 20% overnight?
Have I calculated my Upper Break-even?
Am I prepared to close this trade immediately if it hits my danger zone?

The 'Free' Trade FallacyRead more

Novice traders often see a Ratio Spread that pays a $0.50 credit and think, "I can't lose if it goes down, so it's a free trade!"

While true on the downside, the Margin Requirement for a ratio spread is much higher than a standard spread because of the naked short option. Brokers treat that extra call as a "Naked Short Call," which carries significant capital risk. Always respect the tail.

Ratio Spread