Bear Ratio Spread is an advanced option trading strategy. This strategy is not suitable for beginner & is mainly used by traders.
Know everything about this trading strategy used in bear market condition.
About Bear Ratio Spread
Essentially, the Bear Ratio Spread options trading strategy is an extension and advanced form of bear put spread. The difference between the two arises from the fact that the Bear Ratio Spread is a complicated strategy.
Thus, it brings the element of more risk and flexibility to this strategy. Another factor which makes it different than a bear put option is that the investor does not write the same number of options as they purchase.
On the contrary, the investor uses a specific ratio of calls and puts to execute this strategy. Due to this ratio, the upfront costs involved in the strategy come down. And at the same time, the potential to earn a profit increases.
The investor stands to gain in either situation, no matter if the security falls or rises. Due to this, the strategy happens to be a complex one, which is why beginners must steer clear of it.
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What is the right time to use the Bear Ratio Spread Options Trading Strategy?
By its nature, the Bear Ratio Spread is a flexible trading strategy. The investor takes a position in this strategy at a time when they expect the price of an underlying security to fall.
However, it is significant to note that the investor has a fair expectation of the quantum by which the security might fall.
Thus, the investor can plan a specific ratio of calls and puts. And they can decide the strike price for which they may want to enter the strategy.
Based on the ratio of calls and puts and the strike prices chosen by the investor, the overall cost of the strategy may rise or fall. Likewise, the planning of the investor can impact the overall profits which accrue to an investor.
For an advanced and experienced investor, it is no big deal to adjust the elements of the strategy to their benefit.
They need to determine their outlook to a specific condition of security. Then they can decide how they may want to achieve their target.
The strategy involves making use of two separate transactions. The buyer will ideally buy a certain number of puts and also write a significant number of puts.
Owing to the flexible nature of the strategy, the investor is at ease to choose the strike prices for which they may want to enter these options.
The idea behind adjusting the call to write ratio and selecting the strike prices is that the investor seeks to get the maximum return from their position. As such, there is no strict rule regarding the ratio of strike prices.
However, the investor must plan the strategy only up to his knowledge and skill in that area. It is vital to understand that the choice of strike prices will determine the profit which the investor finally makes.
What is the potential to earn a profit or incur a loss?
The basic direction of the success of the strategy lies on a road down south. So, if underlying security falls in price, the strategy will reap profits for the investor.
Though, by design, this strategy yields the best profits when the price of the security moves by a slight margin.
If on the other hand, the price starts falling by a severe margin, the investor may even lose money.
If the price of the security falls down to the level of the strike prices chosen by the investor, the investor will realise the maximum profit on this strategy.
As long as the investor trades on a debit spread, there will be a loss for them only if the price of the security remains stuck at the same price or if it starts rising.
On the other hand, if the investor trades on a credit spread, a stable or increasing price of the security will profit the investor.
Find out other Bear Option Trading Strategy here
|Long Put||Bear Call Spread||Bear Butterfly Spread|
|Bear Put Ladder Spread||Short Bear Ratio Spread||Bear Put Spread|
How to execute a Bear Ratio Spread Options Strategy?
Let us take an example to understand how the strategy plays out and how an investor can benefit from it.
So, let us assume that the price of a security is trading at INR 50 at present. Due to the forces of the market and existing market conditions, you expect the price to fall down to INR 46.
At present, at the money put options on this stock are trading for INR 2 each at a strike price of INR 50. The out of the money put options on the stock are trading for INR 0.2 each at a strike price of INR 46.
So, you decide to enter the following two trades:
- You purchase 1 put options contract for a strike price of INR 50. Each contract contains 100 options each and costs you INR 200.
- You write 2 put options contracts for a strike price of INR 46. Each contract contains 100 options and you receive a credit of INR 40.
As a result of these trades, you have entered into a Bear Ratio Spread for a net debit of INR 160.
Now, on the date of expiry, the following situations can occur:
- The stock price may continue to remain the same. Thus, the options in contract 2 above will expire and become worthless. So, your liabilities get cancelled. The options in contract 1 above will expire and become worthless as well. No returns will accrue to the investor and the amount of net debit spread will remain a loss for the investor.
- The price of the stock may go down to INR 46. Since the options in contract 2 above are at the money and hence, they will expire. However, the options in contract 1 above will yield a benefit of INR 400 to the investor. After reducing the amount of INR 160 of net debit, the total profit remaining with the investor will be INR 240.
- The price of the stock may go down to INR 42. Since the options in contract 2 above will expire in the money, total liability of INR 800 will emerge. The options in contract 1 above will also expire and will be worth around INR 800. Thus, the value of contracts 1 and 2 will cancel out each other. The investor will bear the brunt of INR 160 as their final loss.
Beyond this point,
If the stock price still continues to fall, the quantum of loss will start rising. Thus, if at any time the investor feels that the prices of the security are not turning the way they had expected, they can close the position by exiting from the strategy.
It is clear that there is a capping on the amount of maximum profit which can accrue to an investor. However, there is no clear limit on the amount of loss which can occur to the investor.
Basically, the extent of losses relies on the nature of the strategy and whether the investor has created a credit or debit spread.
The ratio of calls and puts has an equal role to play in the accrual of profits or losses. The investor may need to carry out several calculations while planning the strategy to determine the exact extent of both.
What are the advantages and disadvantages of Bear Ratio Spread?
The huge chunk of benefit from this strategy comes from the fact that the trader has a flexible approach to follow.
The investor is at a real position to determine the extent of profits which they wish to earn.
It is easy to adjust the ratio of calls and puts and the strike prices to decide what the investor wants to earn.
However, on the other hand, the flexibility of this strategy itself is its biggest disadvantage.
It can get too complicated and only an experienced investor can really manage the strategy at one point.
To Conclude Bear Ratio Spread
As long as an investor understands the operation of this strategy, it is quite effective and fulfilling for most investors.
But the fact remains that the strategy is a complex one. It requires immense understanding on the part of the investor.
This includes knowledge of the ratio of calls and puts and the strike prices to use. The strategy is not inviting enough for beginners due to its complex nature.
As such, it is a function that only experienced investors can perform and trade in. The level of adjustment and flexibility of the strategy certainly makes it attractive for most investors.
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