1x2 ratio vertical spread with puts

  • The Options Institute at CBOE®

Potential goals

To profit from a stock price move to the strike price of the short puts with limited upside risk.

Explanation

Example of 1x2 ratio vertical spread with puts

Buy 1 XYZ 100 put at 3.50
Sell 2 XYZ 95 puts at 1.50 each

A 1x2 ratio vertical spread with puts is created by buying one higher-strike put and selling two lower-strike puts. The second short put can either be cash-secured or uncovered (naked). This strategy can be established for either a net debit (as seen in the example) or for a net credit, depending on the time to expiration, the percentage distance between the strike prices and the level of volatility. Profit potential is limited, and the maximum profit is realized if the stock price is at the strike price of the short puts at expiration. Below the breakeven point risk is substantial, because the stock price can fall to zero.

Maximum profit

If the position is created for a net debit (cost), profit potential is limited to the difference between the strike prices minus the net debit including commissions. In the example above, the maximum profit is 4.50, because the higher strike price minus the lower strike price is 5.00 (100.00 – 95.00) and the net debit is 0.50. Therefore, 5.00 – 0.50 = 4.50.

If the position is created for a net credit (amount received), profit potential is limited to the difference between the strike prices plus the net credit less commissions. If the position had been established for net credit of 50 cents (0.50), the maximum profit would be 5.50, because the higher strike price minus the lower strike price is 5.00 (100.00 – 95.00) and the net credit would have been 0.50. Therefore, 5.00 + 0.50 = 5.50.

Maximum risk

On the downside, risk is substantial, because the risk of the short put is the same as the risk of long stock below the breakeven point.

On the upside, potential risk depends on whether the position is established for a net debit or a net credit. If established for a net debit, the maximum risk is equal to the net debit including commissions. If established for a net credit including commissions, there is no upside risk. If the stock price is above the higher strike price at expiration, then all puts expire worthless and the net credit is kept as a profit.

Breakeven stock price at expiration

If the position is established for a net debit, there are two breakeven points:
Higher breakeven point: Higher strike price minus the net debit
In this example: 100.00 − 0.50 = 99.50
Lower breakeven point: lower strike price minus the maximum profit
In this example: 95.00 − 4.50 = 90.50

If the position is established for a net credit, there is one breakeven point:
Assuming the position is established for a net credit of 50 cents (0.50):
Breakeven point: Lower strike price minus the maximum profit
95.00 − 5.50 = 89.50

Note: If this position is established for a net credit, there is no “higher breakeven point.” If the stock price is above the higher strike price at expiration, then all puts expire worthless, and the net credit is kept as profit.

Profit/Loss diagram and table: 1x2 ratio vertical spread with puts

Buy 1 XYZ 100 put at 3.50
Sell 2 XYZ 95 puts at 1.50 each
Stock Price at Expiration Long 1 100 Put Profit/(Loss) at Expiration Short 2 95 Puts Profit/(Loss) at Expiration Net Profit/(Loss) at Expiration
104 (3.50) +3.00 (0.50)
103 (3.50) +3.00 (0.50)
102 (3.50) +3.00 (0.50)
101 (3.50) +3.00 (0.50)
100 (3.50) +3.00 (0.50)
99 (2.50) +3.00 +0.50
98 (1.50) +3.00 +1.50
97 (0.50) +3.00 +2.50
96 +0.50 +3.00 +3.50
95 +1.50 +3.00 +4.50
94 +2.50 +1.00 +3.50
93 +3.50 (1.00) +2.50
92 +4.50 (3.00) +1.50
91 +5.50 (5.00) +0.50
90 +6.50 (7.00) (0.50)
89 +7.50 (9.00) (1.50)
88 +8.50 (11.00) (2.50)

Appropriate market forecast

A 1x2 ratio vertical spread with puts realizes its maximum profit if the stock price is at the strike price of the short puts at expiration. The forecast, therefore, can either be “neutral” or “modestly bearish,” depending on the relationship of the stock price to the strike prices of the puts when the position is established.

If the stock price is at or near the strike price of the short puts when the position is established, then the forecast must be for continued stock price action near the strike price of the short puts (neutral).

If the stock price is above the strike price of the short puts, and possibly above the strike price of the long put, when the position is established, then the forecast must be for the stock price to fall to the strike price of the short puts at expiration (modestly bearish).

While one can imagine a scenario in which the stock price is below the strike price of the short puts and in which a 1x2 ratio vertical spread with puts would profit from bullish stock price action, it is most likely that another strategy would be a more profitable choice for a bullish forecast.

Strategy discussion

A 1x2 ratio vertical spread with puts is the same as buying a bear put spread and selling another put, either cash secured or uncovered (naked). The premium from the short put is used to at least partially pay for the bear put spread. The position profits from time decay as the underlying stock trades near the strike price of the short puts.

This strategy can be used by both stock-oriented investors and aggressive traders.

For stock-oriented investors, a ratio vertical spread with puts can be used to target a purchase price for stock that is below the current stock price and further below the current stock price than the breakeven point for a simple at-the-money cash-secured short put. In the example above, the breakeven point and target purchase price is 90.50 versus 96.50 for selling the 100-strike put.

For aggressive traders, while the “low” net cost to establish the strategy – or possible net credit – is viewed as an attractive feature by some, the strategy has substantial risk from the uncovered put. There is also a margin requirement for the short put in additional to the up-front cash requirement for the bear put spread. This strategy, therefore, is suitable only for experienced traders who are suited to accept the substantial risk.

For aggressive traders, choosing a 1x2 ratio vertical spread with puts requires both a high tolerance for risk and trading discipline. A high tolerance for risk is required, because potential risk is unlimited on the upside. Trading discipline is required because the ability to “cut losses short” is an attribute of trading discipline. Many traders who use this strategy have strict guidelines – which they adhere to – about closing positions when the market goes against the forecast.

Impact of stock price change

“Delta” estimates how much a position will change in price as the stock price changes. Long puts have negative deltas, and short puts have positive deltas. The net delta of a 1x2 ratio vertical spread with puts varies from −1.00 to +1.00, depending on the relationship of the stock price to the strike prices of the options.

The position delta approaches −1.00 if the long put is in the money and the short puts are out of the money as expiration approaches. In this case, the delta of the long put approaches −1.00, and the deltas of the short puts approach zero.

When the stock price is below the strike price of the short puts as expiration approaches, the position delta approaches +1.00, because the delta of the long put approaches −1.00 and the deltas of the two short puts approach +1.00 each.

The position delta approaches zero as the stock price rises above the strike price of the long put, because the deltas of all the puts approach zero.

Impact of change in volatility

Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. Long options, therefore, rise in price and make money when volatility rises, and short option positions rise in price and lose money when volatility rises. When volatility falls, the opposite happens; long options lose money and short options make money. “Vega” is a measure of how much changing volatility affects the net price of a position.

Since a 1x2 ratio vertical spread with puts has one long put and two short puts, rising volatility generally hurts the position and falling volatility generally helps. In the language of options, this is “net negative vega.” As expiration approaches, however, the impact of changing volatility depends on the relationship of the stock price to the strike prices of the options. If the stock price is close to the strike price of the long put, then the net vega tends to be positive. If the stock price is close to the strike price of the short puts, then the net vega tends to be negative. The net vega approaches zero if the stock price rises above the higher strike or falls sharply below the lower strike.

Impact of time

The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion. “Theta” is a measure of how much time erosion affects the net price of a position. Long option positions have negative theta, which means they lose money from time erosion, if other factors remain constant; and short options have positive theta, which means they make money from time erosion.

Since a 1x2 ratio vertical spread with puts has one long put and two short puts, the impact of time erosion is generally positive. In the language of options, this is a “net positive theta.” As expiration approaches, however, the impact of time erosion depends on the relationship of the stock price to the strike prices of the options. If the stock price is close to the strike price of the long put, then the net theta tends to be negative and time erosion hurts the position. If the stock price is close to the strike price of the short puts, then the net theta tends to be positive and time erosion benefits the position.

Risk of early assignment

Stock options in the United States can be exercised on any business day, and holders of short stock option positions have no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options.

While the long put in 1x2 ratio vertical spread with puts has no risk of early assignment, the short puts do have such risk. Early assignment of stock options is generally related to dividends, and short puts that are assigned early are generally assigned on the ex-dividend date. In-the-money puts whose time value is less than the dividend have a high likelihood of being assigned.

If assignment is deemed likely, there are three possibilities. First, one of the two short puts is assigned. In this case, 100 shares of stock are purchased and the long put and the second short put remain open. Second, both of the short puts are assigned. In this case, 200 shares are purchased and the long put remains open. Third, neither put is assigned. No matter how likely assignment may seem, there is no assurance that it will occur. In this case the 1x2 ratio vertical spread with puts remains intact.

If early assignment of one or both puts does occur, stock is purchased, and a long stock position of 100 shares or 200 shares is created. If a long stock position is not wanted, 100 shares can be closed by exercising the long put, but the second 100 shares must be sold in the marketplace. Note, however, that whichever method is used, the date of the stock sale will be one day later than the date of the purchase. This difference will result in additional fees, including interest charges and commissions. Assignment of a short put might also trigger a margin call if there is not sufficient account equity to support the long stock position.

Potential position created at expiration

The position at expiration depends on the relationship of the stock price to the strike prices. If the stock price is at or above the strike price of the long put (higher strike), then all options expire worthless and there is no stock position.

If the stock price is below the higher strike but not below the lower strike, then the long put is exercised and the short puts expire. Exercising a long put causes stock to be sold at the strike price, so the result is a short stock position. Since long options are exercised at expiration if they are one cent (0.01) in the money, if short shares are not wanted, the long put must be sold prior to expiration.

If the stock price is below the lower strike price then the long put is exercised and both short puts are assigned. In the example above, this means that 100 shares are sold and 200 shares are purchased. The result is a position of long 100 shares. If the stock price is below the lower strike immediately prior to expiration, and if a position of long 100 shares is not wanted, then one of the short puts must be closed.

Other considerations

In a “ratio spread” there is a difference between the number of options purchased and the number of options sold. The term “vertical” in the name of this strategy implies that more options are sold than purchased. In contrast, in the “1x2 ratio volatility spread with puts,” the term “volatility” implies that more options are purchased than sold.

This strategy – the 1x2 ratio vertical spread with puts – is also known as a “front spread,” because it is generally used with short-term, or “front-month,” options as opposed to longer-term, or “back-month,” options. Shorter-term options are more suitable for this strategy, because this strategy profits mostly from time decay when the short puts are at the money and close to expiration. At-the-money short-term options experience a greater rate of time decay than longer-term options.