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Understanding Bear Ratio Spread
Just like how we have the bull ratio spread, there’s also a similar options strategy that deals with put options - the bear ratio spread. In this chapter, we’re going to be looking at what the options strategy actually is, how you can set it up, and the kind of results that you’re likely to get. So, let’s begin.
What is the bear ratio spread?
Also known as a put ratio spread, ratio put spread, and ratio bear spread, this options strategy is used by traders when they have a bearish outlook on an asset. The bear ratio spread trading strategy allows you to generate profits when the price of the asset moves declines.
And just like the previous strategy that we saw, the bear ratio spread can also sometimes generate gains even when the price of the asset stays the same or goes up slightly. This strategy is ideal for times when the market doesn’t seem to be moving by much.
As with all kinds of ratio spreads, the number of short and long positions are uneven even in the bear ratio spread trading strategy. It is usually in the 2:1 range, which means that for every two short positions, there’s only one long position. However, this ratio can be almost anything depending on your needs and requirements. Some experienced traders use a 3:1 or a 4:1 ratio for setting up their trades as well.
How to set up a bear ratio spread?
From the previous chapter, you know how to set up a bull ratio spread. So, it should be easy for you to do the same for a bear ratio spread as well. The only difference between the two is that this options trading strategy involves two put options with different intrinsic values, but with the same expiry. Here’s a quick look at what you need to do.
- Sell 2 lots of out of the money (OTM) put options
- Purchase 1 lot of at the money (ATM) put options
As you can see from the above two options, this is essentially a 2:1 approach since the number of puts that you sell is twice the number of puts that you purchase.
How does the bear ratio spread work?
Here’s an example that can help you understand the bear ratio spread trading strategy better. But before we get to the thick of things, let’s first quickly run through a few of the assumptions that we’re going to make.
- You have a slightly bearish outlook on ICICI Prudential Life Insurance Company.
- The shares of the company are currently trading at Rs. 560.
- However, you don’t expect the stock to move by much and feel that it wouldn’t fall below Rs. 500 (which would be its resistance).
- And so, to take advantage of this situation, you decide to set up a bear ratio spread.
- The lot size of the options contract of this stock is set at 1,500.
- The expiry date of all the options that we’re going to consider would be May, 2021.
Now that we’re done with the assumptions, here’s what you would have to do to set up a bear ratio spread trading strategy.
- Sell 2 lots of out of the money (OTM) put options, which in this case would be ICICIPRULI MAY 500 PE. Let’s say that the premium for this put option is currently at Rs. 3 per share. By selling 2 lots (which is 3,000 shares) of OTM put options, you would receive Rs. 9,000 (Rs. 3 x 3,000).
- Purchase 1 lot of at the money (ATM) put options, which in this case would be ICICIPRULI MAY 560 PE. Assume that the premium for the put option is currently at Rs. 18 per share. So, to purchase 1 lot (which is 1,500 shares) of ATM put options, you would have to pay Rs. 27,000 (Rs. 18 x 1,500).
The net amount (debit) that you would have to pay for these two options trades comes up to Rs. 18,000 (Rs. 27,000 - Rs. 9,000).
Scenario 1: The share price falls down below Rs. 500 on expiry
Now, let’s see what would happen if the share price of ICICI Prudential Life Insurance Company falls down below Rs. 500. Assume that the price settled at around Rs. 480 on expiry.
- The ATM put options that you purchased - ICICIPRULI MAY 560 PE would turn up a profit of Rs. 80 per share (Rs. 560 - Rs. 480). This comes up to a total profit of Rs. 1,20,000 (Rs. 80 x 1,500).
- The two lots of OTM put options that you sold - ICICIPRULI MAY 500 PE would turn into a loss of Rs. 20 per share (Rs. 500 - Rs. 480). This comes up to a total loss of Rs. 60,000 (Rs. 20 x 3,000).
In this scenario, your total profit from the bear ratio spread would be Rs. 42,000 (Rs. 1,20,000 - Rs. 60,000 - Rs. 18,000).
Scenario 2: The share price ends at Rs. 500 on expiry
On the other hand, if the share price of ICICI Prudential Life Insurance were to end exactly at Rs. 500 on expiry, here’s what would happen.
- The ATM put options that you purchased - ICICIPRULI MAY 560 PE would make a profit of Rs. 60 per share (Rs. 560 - Rs. 500), which comes up to a profit of Rs. 90,000 (Rs. 60 x 1,500).
- The two lots of OTM put options that you sold - ICICIPRULI MAY 500 PE would expire worthless since the strike price is the same as the spot price.
In this case, your total profit from the bear ratio spread would be Rs. 72,000 (Rs. 90,000 - Rs. 18,000).
Scenario 3: The share price goes up Rs. 560 or stays on Rs. 560 on expiry
Alternatively, if the share price stays stable at Rs. 560 or goes up past Rs. 560, here’s what could happen.
- The ATM put options that you purchased - ICICIPRULI MAY 560 PE would expire worthless.
- The two lots of OTM put options that you sold - ICICIPRULI MAY 500 PE would also expire worthless.
And so, your total loss from the bear ratio spread would be the net debt amount of Rs. 18,000 that you had to pay due to the trades that you made.
As you can see here from the above scenarios, you incur maximum loss when the share price stays at Rs. 560 or goes above it. However, your loss is limited to the net amount that you paid for conducting the options trades. With this, we’re done with ratio spread strategies. In the next chapter, we’ll be looking at more options trading strategies.
A quick recap
- The bear ratio spread is an options trading strategy that traders use when they have a bearish outlook.
- The strategy is designed to generate profits when the price of the asset moves down slightly.
- Depending on the circumstances, it can also generate gains if the asset price stays stable or even goes up slightly.
- The reason for the inclusion of the word ‘ratio’ in this strategy also has to do with the fact that the number of short and long positions are uneven, thereby creating a ratio.
- Generally, the ratio used by traders is 2:1, where the number of short positions is twice the number of long positions.
- The strategy involves two call options with different intrinsic values, but with the same expiry.
- Essentially, you sell 2 lots of out of the money (OTM) put options and purchase 1 lot of at the money (ATM) put options.