Explanation

Put ratio spread is a multi-leg, neutral strategy with undefined risk and limited profit potential that involves buying in-the-money put options and selling more out-of-the-money put options of the same underlying and expiry but at a different strike price. If the strategy is initiated for a credit, the trader can earn in two ways: the premium received while executing the strategy and the width of the spread between the long and short put options. If the strategy is initiated for a net debit, the trader will only profit when the underlying prices fall to the short put option and the trader gains from the spread between the long and short put options.

Risk:

Max loss can be seen if the price of the underlying asset takes a sudden nose dive below the breakeven point. The loss would be limited yet significant till the security price becomes worthless.

Reward:

Max gain would be realized if the underling price at expiry fall to short put option strike price. The short puts will expire worthless and gains would be made from difference between long and short strike put.

Construction

Buy 1 ITM Put Option

Sell 2O TM Put Options

Payoff Chart

Example

Nifty is trading at 17850 levels and the trader holds a neutral view on nifty with low volatility in the index. He implemented ratio put spread which involved buying 17950 put by paying the premium of Rs 165 and selling 2 17800 puts at a premium of 55 each. Net funds outflow initially came out to be Rs. 2750 (165 – (55*2)) * 50

Scenario 1:

If the market moved against the trader assumption, then the trade will result in a loss. one short position will be compensated by the long position but another will result in a loss as sown in the chart above.

Scenario 2:

If the market moves till the short put option, the trade will result in a gain, as the long position will be in positive and short position will expire worthless.

Scenario 3:

Last scenario being, if the market rises on a positive news and crosses above the long put option. All the option will expire worthless and the trader will lose the net premium paid and hence end up in loss.