The Complete Book of Option Spreads and Combinations: Strategies for Income Generation, Directional Moves, and Risk Reduction, + Website

CHAPTER 14

Ratio Spreads and Back Spreads

Nearly all the spreads and combinations we’ve examined so far offer one element, an option or a vertical spread, versus or in combination with only one other element, an option or a vertical spread or shares of stock or cash to buy the shares if they’re put to us. Finally, in ratio spreads and back spreads, we look at one option at a strike price versus more than one option at a strike price that is farther from at-the-money.

Ratio spreads buy one option and sell two options of the same type and expiration with a strike price that is farther from at-the-money. The result is a trade that makes money if there’s a modest move in a particular direction, upward if we’re using a call ratio spread, and downward if we’re using a put ratio spread, but since we’re net short an option—we sold two options but bought only one—the trade losses money if the move is too extreme. Since we’re net short an option, the loss can be substantial.

Back spreads, however, sell one option and buy two options of the same type and expiration with a strike price that is farther from at-the-money. A back spread is a trade that requires a substantial move, upward for a call back spread and downward for a put back spread. If the underlying moves only a little, even though it moves in our desired direction, then a back spread can lose money, but a substantial move in the expected direction will generate unlimited returns for a call back spread and returns that are limited ...