Basics of Spreading: Ratio Spreads and Backspreads

Basics of Spreading: Ratio Spreads and Backspreads
What is a Spread? Download What is a Spread?

Review the links below for detailed information.
Download: Ratio Spreads and Backspreads
Terms and Characterizations: Part 1
Terms & Characterizations: Part 2
Spread Order Execution
Calculating Profit & Loss
Early Assignment Risk
More on Terminology
The Strategies
The spreads discussed in this series, may be categorized with respect to their risk/reward
profiles.
Profit limited & Loss limited

Moderately Bullish Moderately Bearish Neutral
Bull Call Spread X
Bear Call Spread X
Bear Put Spread X
Bull Put Spread X
Long Call Time Spread X
Long Put Time Spread X
Long Call Butterfly X
Long Put Butterfly X
Iron Butterfly X
Long Call Condor X
Long Put Condor X
Iron Condor X
Profit not limited & Loss limited

Very Bullish Very Bearish Neutral
Long Straddle X
Long Strangle X
Call Backspread X
Put Backspread X
Profit limited & Loss not limited

Neutral to slightly Bullish Neutral to slightly Bearish Neutral
Ratio Call Spread X
Ratio Put Spread X
Short Straddle X
Short Strangle X
NOTE: For each spread example discussed in this class it is assumed that all transactions are opening
ones. In other words, an investor would initially have no position, but after making the transactions
described would have the spread position under discussion.
In order to simplify the computations, commissions and other costs have not been included in the
examples used in this course and may be significant. These costs will impact the outcome of all stock
and options transactions and must be considered prior to entering into any transactions. Investors
should consult their tax advisor about any potential tax consequences.
Call Backspreads
General Nature & Characteristics
A call backspread is made up entirely of call options on the same underlying stock
(or index). It’s constructed by purchasing two or more calls with one strike price
and selling (writing) fewer calls than purchased with a lower strike price but same
expiration month. The result is a position comprised of long higher-strike calls and
short lower-strike calls at a ratio of long to short that’s greater than 1:1 (2:1, 3:1,
3:2 etc.). It therefore includes extra long call contracts.
Call backspread = buy higher-strike calls + sell fewer lower-strike call(s)
Debit vs. Credit

A call backspread may be established for a net debit, a net credit, or even money. This depends
entirely on the prices of the options chosen, and the ratio of long contracts to short.
Call backspread = debit, credit or even money spread
Example
To establish a call backspread with XYZ options, an investor might buy 2 XYZ June 65 calls for $1.75,
and at the same time sell (write) 1 XYZ June 60 call for $3.50. The result is the investor holding an XYZ
June 65/60 call backspread at a 2:1 ratio for even money ($3.50 paid vs. 2 x $1.75 received).
XYZ June 65/60 Call Backspread

Action Quoted Price* Total Price*
Buy 2 XYZ June 65 calls - $1.75 - $350.00
Sell 1 XYZ June 60 call + $3.50 + $350.00
Even 0 0
*Excluding commissions
XYZ June 65/60 Call Backspread

Long 2 XYZ June 65 calls
Short 1 XYZ June 60 call
Expectation
The call backspread is a bullish strategy, and/or it is generally used when high volatility in the
underlying stock (or index) is expected. An investor employing this strategy expects the underlying stock
price (or index level) to close high above the long call strike price at expiration.
Call backspread: bullish
Motivation for Spreading

Since the investor is bullish on the underlying stock (or index), he is buying call contracts. But, he is also
selling fewer number of lower-strike calls to finance (at least partially) the cost of those long calls. And
since he is long more calls than short, he hopes the level of the underlying stock (or index) will increase.
Call backspread: pay for higher-strike calls by selling fewer lower-strike calls
Risk vs. Reward
Maximum Profit
On the upside, the maximum profit for a call backspread is unlimited because there are more (excess)
long call contracts than short ones. The more excess calls, the greater the upside profit can be.
Maximum profit = unlimited
Maximum Loss
The maximum loss for a call backspread is limited, and will occur if the underlying stock (or index)
closes exactly at the long call strike price at expiration. Under this circumstance, the short calls would
be repurchased for their intrinsic value (the difference between the calls’ strike prices), and the long
calls would expire at-the-money and worthless. The maximum loss amount may be calculated with the
following formula:
Maximum loss =
(strike price differential x number of short calls) – net credit received (or + net debit paid)
(Underlying at long strike at expiration)
Downside Profit/Loss
If the spread was initially established at a net debit, this debit amount paid would be the limited
downside loss. If the spread was initially established at a net credit, this credit amount received would
be the limited downside profit. Either of these will be seen if the underlying stock (or index) closes at or
below the lower, short call strike price at expiration. If the spread was initially established for even
money, there is no downside profit or loss.
Downside = loss of debit paid or profit of credit received

(Underlying at/below short strike at expiration)
Break-Even Point
The break-even point (BEP) for a call backspread at expiration will occur on the upside of the long call
strike price. It may be calculated in advance with the following formula:
Break-even point =
higher strike price + (points of maximum loss number of excess long calls)
Profit & Loss Before Expiration
Before expiration, an investor can take a profit or cut a loss by closing out the spread. This involves
selling the long call(s) and buying the short call(s), and these closing trades may be executed
simultaneously in one spread transaction. Profit or loss would simply be the net difference between the
debit initially paid (or credit received) for the spread and the credit received (or debit paid) at its closing.
Effect of Volatility
An increase in volatility generally has a positive effect on a call backspread; a decrease in volatility
generally has a negative effect.
Effect of Time Decay
Time decay generally has a negative effect on a call backspread because there are more long calls
than short ones. This is especially the case if the underlying stock (or index) stabilizes around the long
strike price as expiration nears.
Call Backspread - Continued

Example
XYZ June 65/60 Call Backpread

2:1
Long 2 XYZ June 65 calls
Short 1 XYZ June 60 call
Even money (no credit/debit)
Maximum Profit
On the upside, this 2:1 call backspread has one extra (excess) long call contract. Because of this, the
potential profit is theoretically unlimited.
Maximum profit = unlimited
Maximum Loss
The maximum loss for this call backspread would occur if the underlying stock (or index) closed exactly
at the long call strike price of $65 at expiration. The short 60 call would have an intrinsic value of $5,
and the long 65 calls would expire at-the-money and with no value. This loss amount can be calculated
in advance according to the formula given earlier:
Maximum loss =
($5.00 strike difference x 1 short call) + 0 credit/debit = $5.00, or $500 total
On the downside, this call backspread has no profit or loss potential because it was initially established
for even money.
Break-Even Point
At expiration, the break-even point for this call backspread would be a closing underlying stock price (or
index level) equal to $65 (higher strike price) + ($5.00 points of maximum profit 1 excess long call) =
$70.
BEP = $65 higher strike + ($5.00 maximum loss 1 excess long call) = $70
XYZ June 65/60 Call Backpread 2:1

Even Money (no credit/debit)
Results at Expiration
Long 2 Short 1
Spread
XYZ Price 65 Calls 60 Call
Profit/Loss*
Profit/Loss* Profit/Loss*
58 – $350 + $350 0
60 – $350 + $350 0
62 – $350 + $150 – $200
64 – $350 – $50 – $400
65 – $350 – $150 – $500
66 – $150 – $250 – $400
68 + $250 – $450 – $200
70 + $650 – $650 0
72 + $1050 – $850 + $200
74 + $1450 – $1050 + $400
76 + $1850 – $1250 + $600
78 + $2250 – $1450 + $800
80 + $2650 – $1650 + $1000
Assignment Risk
Assignment on any Equity option or American-style index option can, by contract terms, occur at any
time before expiration, although this generally occurs when the option is in-the-money.
Equity Options
For an equity call option, early assignment usually occurs under specific circumstances; such as when
underlying shareholders are about to be paid a dividend. Assignment at that time might be expected
when the dividend amount is greater than the time value in the call’s premium, and notice of assignment
may be received as late as the ex-dividend date. If a call backspread holder is assigned early on short
calls, then he may exercise as many long calls and buy shares to fulfill the assignment obligation.
American-Style Index Options

If early assignment is received on a short call of a call backspread, the cash settlement procedure for
index options will create a debit in the investor’s brokerage account equal to the cash settlement
amount. This cash amount is determined at the end of the day the long call is exercised by its owner.
After receiving assignment notification, usually the next business day, when the investor exercises his
long call the cash settlement amount credited to his account will be determined at the end of that day.
There is a full day’s market risk if the long option is not sold during the trading day assignment is
received.
Put Backspread
A put backspread is made up entirely of put options on the same underlying stock
(or index). It’s constructed by purchasing two or more puts with one strike price
and selling (writing) fewer puts than purchased with a higher strike price but same
expiration month. The result is a position comprised of long lower-strike puts and
short higher-strike puts at a ratio of long to short that’s greater than 1:1 (2:1, 3:1,
3:2 etc.). It therefore includes extra long put contracts.
Put backspread = buy lower-strike puts + sell fewer higher-strike put(s)
Debit vs. Credit

A put backspread may be established for a net debit, a net credit, or even money. This depends
Put backspread = debit, credit or even money spread
Example
To establish a put backspread with XYZ options, an investor might buy 2 XYZ June 55 puts for $2.00,
and at the same time sell (write) 1 XYZ June 60 put for $4.00. The result is the investor holding an XYZ
June 60/55 put backspread at a 2:1 ratio for even money ($4.00 received vs. 2 x $2.00 paid).
XYZ June 55/60 Put Backspread

Buy 2 XYZ June 55 puts - $2.00 - $400.00
Sell 1 XYZ June 60 put + $4.00 + $400.00
Even 0 0
XYZ June 55/60 Put Backspread

Long 2 XYZ June 55 puts
Short 1 XYZ June 60 put
Expectation
The put backspread is a bearish strategy, and/or it is generally used when high volatility in the
underlying stock (or index) is expected. An investor employing this strategy expects the underlying stock
price (or index level) to close well below the long put strike price at expiration.
Put backspread: bearish

Since the investor is bearish on the underlying stock (or index), he is buying put contracts. But, he is
also selling fewer number of higher-strike puts to finance (at least partially) the cost of those long puts.
And since he is long more puts than short, he hopes the level of the underlying stock (or index) will
decrease.
Put backspread: pay for lower-strike puts by selling fewer higher-strike puts
Risk vs. Reward
Maximum Profit
On the downside, the maximum profit for a put backspread is substantial because there are more
(excess) long put contracts than short ones. The more excess puts, the greater the downside profit can
be. It is limited only by the underlying stock (or index) declining to no less than zero.
Maximum profit = substantial
Maximum Loss
The maximum loss for a put backspread is limited, and will occur if the underlying stock (or index level)
closes exactly at the long put strike price at expiration. Under this circumstance, the short puts would be
repurchased for their intrinsic value (the difference between the puts’ strike prices), and the long puts
would expire at-the-money and worthless. The maximum loss amount may be calculated with the
following formula:
Maximum loss =
(strike price differential x number of short puts) – net credit received (or + net debit paid)
(Underlying at long strike at expiration)
Upside Profit/Loss
If the spread was initially established at a net debit, this debit amount paid would be the limited upside
loss. If the spread was initially established at a net credit, this credit amount received would be the
limited upside profit. Either of these will be seen if the underlying stock (or index) closes at or above the
higher, short put strike price at expiration. If the spread was initially established for even money, there
is no upside profit or loss.
Upside = loss of debit paid or profit of credit received

(Underlying at/above short strike at expiration)
Break-Even Point
The break-even point (BEP) for a put backspread at expiration will occur on the downside of the long
put strike price. It may be calculated in advance with the following formula:
Break-even point =
lower strike price – (points of maximum loss number of excess long puts)
selling the long put(s) and buying the short put(s), and these closing trades may be executed
An increase in volatility generally has a positive effect on a put backspread; a decrease in volatility
Time decay generally has a negative effect on a put backspread because there are more long puts than
short ones. This is especially the case if the underlying stock (or index) stabilizes around the long strike
price as expiration nears.
Put Backspread - Continued

Example
XYZ June 55/60 Put Backpread

2:1
Long 2 XYZ June 55 puts
Short 1 XYZ June 60 put
Maximum Profit
Maximum Profit On the downside, this 2:1 put backspread has one extra (excess) long put contract.
Because of this, the potential profit is substantial. It is limited only by the underlying stock (or index)
declining to no less than zero.
Maximum profit = substantial
Maximum Loss
The maximum loss for this put backspread would occur if the underlying stock (or index) closed exactly
at the long put strike price of $55 at expiration. The short 60 put would have an intrinsic value of $5, and
the long 55 puts would expire at-the-money and with no value. This loss amount can be calculated in
advance according to the formula given earlier:
Maximum loss =
($5.00 strike difference x 1 short put) + 0 (credit/debit) = $5.00, or $500 total
Upside Profit/Loss
On the upside, this put backspread has no profit or loss potential because it was initially established for
even money.
Break-Even Point
At expiration, the break-even point for this put backspread would be a closing underlying stock price (or
index level) equal to $55 (lower strike price) – ($5.00 points of maximum loss 1 excess long put) = $50.
BEP = $55 lower strike – ($5.00 maximum loss 1 excess long put) = $50
XYZ June 55/60 Put Backpread 2:1

Long 2 Short 1
Spread
XYZ Price 55 Puts 60 Put
Profit/Loss*
40 + $2600 – $1600 + $1000
42 + $2200 – $1400 + $800
44 + $1800 – $1200 + $600
46 + $1400 – $1000 + $400
48 + $1000 – $800 + $200
50 + $600 – $600 0
52 + $200 – $400 – $200
54 – $200 – $200 – $400
55 – $400 – $100 – $500
56 – $400 0 – $400
58 – $400 + $200 – $200
60 – $400 + $400 0
62 – $400 + $400 0
Assignment Risk
Equity Options
For an equity put option, early assignment generally occurs when the short put is deep in-the-money,
expiration is relatively near, and its premium has little or no time value. If a put backspread holder is
assigned early on short puts, then he may exercise as many long puts to sell shares purchased via the
assignment obligation.

If early assignment is received on short puts of a put backspread, the cash settlement procedure for
index options will create a debit in the investor’s brokerage account equal to the cash settlement
amount. This cash amount is determined at the end of the day the long put is exercised by its owner.
After receiving assignment notification, usually the next business day, when the investor exercises a long
put the cash settlement amount credited to his account will be determined at the end of that day. There
is a full day’s market risk if the long option is not sold during the trading day assignment is received.
Ratio Call Spread

The ratio call spread is made up entirely of call options on the same underlying
stock (or index). It’s constructed by purchasing one or more calls with one strike
price and selling (writing) more calls than purchased with a higher strike price but
same expiration month. The result is a position comprised of long lower-strike calls
and short higher-strike calls at a ratio of long to short that’s less than 1:1 (1:2, 1:3,
2:3 etc.). It therefore includes naked (uncovered) short call contracts. This
strategy may also be referred to as a call “frontspread.”
Ratio call spread = buy lower-strike call(s) + sell greater number higher-strike call(s)
Debit vs. Credit

A ratio call spread may be established for a net debit, a net credit, or even money. This depends
Ratio call spread = debit, credit or even money spread
Example
To establish a ratio call spread with XYZ options, an investor might buy 1 XYZ June 60 call for $3.00,
and at the same time sell (write) 2 XYZ June 65 calls for $1.50. The result is the investor holding an
XYZ June 60/65 ratio call spread at a 1:2 ratio for even money ($3.00 paid vs. 2 x $1.50 received).
XYZ June 60/65 Ratio Call Spread

Buy 1 XYZ June 60 call - $3.00 - $300.00
Sell 2 XYZ June 65 calls + $1.50 x 2 + $300.00
Even 0 0

Long 1 XYZ June 60 call
Short 2 XYZ June 65 calls
Expectation
The ratio call spread is a neutral to slightly bullish strategy , depending on the strike prices in relation to
the price of the underlying stock (or index level) when it is established. It’s generally used when low
underlying stock volatility is expected , because an investor employing this strategy expects the
underlying stock (or index level) to stabilize and close at the short call strike price at expiration. This
spread can take on a slightly bullish characteristic if the short calls’ strike price is out-of-the-money
when the spread is established.
Ratio call spread: neutral to slightly bullish

Since the investor is neutral on the underlying stock (or index), he expects to profit from the premium
received from writing the short call contracts he anticipates will expire at-the-money and with no value.
Ratio call spread: profit from premium of written calls
Risk vs. Reward
Maximum Profit
The maximum profit for a ratio call spread is limited, and will occur if the underlying stock (or index)
closes exactly at the short call strike price at expiration. Under this circumstance, the long call will be
worth its intrinsic value (the difference between the calls’ strike prices) and the short calls will expire
at-the-money and worthless. The maximum profit amount may be calculated with the following formula:
Maximum profit =
(strike price differential x number of long calls) + net credit received (or net debit paid)
(Underlying at short strike at expiration)
Maximum Loss
On the upside, since more calls are written than purchased the potential loss from the extra, uncovered
short calls is theoretically unlimited. The more uncovered calls, the greater this loss can be.
Maximum loss = unlimited
If the spread was initially established at a net debit, this debit amount paid would be the limited
downside loss. If the spread was initially established at a net credit, this credit amount received would
be the limited downside profit. Either of these will be seen if the underlying stock (or index) closes at or
below the lower, long call strike price at expiration. If the spread was initially established for even
money, there is no downside profit or loss.
Downside = loss of debit paid or profit of credit received

(Underlying at/below long strike at expiration)
Break-Even Point
The break-even point (BEP) for a ratio call spread at expiration will occur on the upside of the short call
strike price. It may be calculated in advance with the following formula:
Break-even point =
higher strike price + (points of maximum profit number of uncovered calls)
selling the long call(s) and buying the short call(s), and these closing trades may be executed
A decrease in volatility generally has a positive effect on a ratio call spread; an increase in volatility
Time decay generally has a positive effect on a ratio call spread because there are more short calls
than long ones. This is especially the case if the underlying stock (or index) stabilizes around the short
strike price as expected.
Ratio Call Spread - Continued

Example

Long 1 XYZ June 60 call
Short 2 XYZ June 65 calls
Maximum Profit
The maximum profit for this ratio call spread would occur if the underlying stock (or index) closed
exactly at the short call strike price of $65 at expiration. The long 60 call would have an intrinsic value of
$5, and the short 65 calls would expire at-the-money and with no value. This profit amount can be
calculated in advance according to the formula given earlier:
Maximum profit =
($5.00 strike difference x 1 long call) + 0 credit/debit = $5.00, or $500 total
Maximum Loss
On the upside, this 1:2 ratio call spread has one uncovered (naked) call contract. Because of this, the
potential loss is theoretically unlimited.
Maximum loss = unlimited
On the downside, this ratio call spread has no profit or loss potential because it was initially established
for even money.
Break-Even Point
At expiration, the break-even point for this ratio call spread would be a closing underlying stock price (or
index level) equal to $65 (higher strike price) + ($5.00 points of maximum profit 1 uncovered call) = $70.
BEP = $65 higher strike + ($5.00 maximum profit 1 uncovered call) = $70
XYZ June 60/65 Ratio Call Spread 1:2

Long 1 Short 2
Spread
XYZ Price 60 Call 65 Calls
Profit/Loss*
58 – $300 + $300 0
60 – $300 + $300 0
62 – $100 + $300 + $200
64 + $100 + $300 + $400
65 + $200 + $300 + $500
66 + $300 + $100 + $400
68 + $500 – $300 + $200
70 + $700 – $700 0
72 + $900 – $1100 – $200
74 + $1100 – $1500 – $400
76 + $1300 – $1900 – $600
78 + $1500 – $2300 – $800
80 + $1700 – $2700 – $1000
Assignment Risk
Equity Options
For an equity call option, early assignment usually occurs under specific circumstances; such as when
underlying shareholders are about to be paid a dividend. Assignment at that time might be expected
when the dividend amount is greater than the time value in the call’s premium, and notice of assignment
may be received as late as the ex-dividend date. If a ratio call spread holder is assigned early on short
calls, then he may exercise as many long calls and buy shares to fulfill the assignment obligation. If
assigned on uncovered calls (i.e., more short calls than he is long) then he must either purchase
underlying shares for delivery to fulfill his assignment obligations, or take a short position in those
shares.

If early assignment is received on covered short calls of a ratio call spread, the cash settlement
procedure for index options will create a debit in the investor’s brokerage account equal to the cash
settlement amount. This cash amount is determined at the end of the day the long call is exercised by
its owner. After receiving assignment notification, usually the next business day, when the investor
exercises an equal number of long calls the cash settlement amount credited to his account will be
determined at the end of that day. There is a full day’s market risk if the long option is not sold during
the trading day assignment is received.
If assigned on uncovered short calls (i.e., more short calls than he is long), the cash settlement
procedure will create a debit in the investor’s brokerage account equal to the total cash settlement
amount.
Ratio Put Spread

A ratio put spread is made up entirely of put options on the same underlying stock
(or index). It’s constructed by purchasing one or more puts with one strike price and
selling (writing) more puts than purchased with a lower strike price but same
expiration month. The result is a position comprised of long higher-strike puts and
short lower-strike puts at a ratio of long to short that’s less than 1:1 (1:2, 3:1, 2:3
etc.). It therefore includes naked (uncovered) short put contracts. This strategy may
also be referred to as a put “frontspread.”
Ratio put spread = buy higher-strike put(s) + sell greater number lower-strike put(s)
Debit vs. Credit

A ratio put spread may be established for a net debit, a net credit, or even money. This depends
Ratio put spread = debit, credit or even money spread
Example
To establish a ratio put spread with XYZ options, an investor might buy 1 XYZ June 60 put for $4.00,
and at the same time sell (write) 2 XYZ June 55 puts for $2.00. The result is the investor holding an
XYZ June 60/55 ratio put spread at a 1:2 ratio for even money ($4.00 paid vs. 2 x $2.00 received).
XYZ June 60/55 Ratio Put Spread

Buy 1 XYZ June 60 put – $4.00 – $400.00
Sell 2 XYZ June 55 puts + $2.00 x 2 + $400.00
Even 0 0

Long 1 XYZ June 60 put
Short 2 XYZ June 55 puts
Expectation
The ratio put spread is a neutral to slightly bearish strategy, depending on the strike prices in relation to
the price of the underlying stock (or index level) when it is established. It’s generally used when low
underlying stock volatility is expected. An investor employing this strategy expects the underlying stock
(or index level) to stabilize and close at the short put strike price at expiration. This spread can take on
a slightly bearish characteristic if the short puts’ strike price is out-of-the-money when the spread is
established.
Ratio put spread: neutral to slightly bearish

Since the investor is neutral on the underlying stock (or index), he expects to profit from the premium
received from writing the short put contracts he anticipates will expire at-the-money and with no value.
Ratio put spread: profit from premium of written puts
Risk vs. Reward
Maximum Profit
The maximum profit for a ratio put spread is limited, and will occur if the underlying stock (or index)
closes exactly at the short put strike price at expiration. Under this circumstance, the long put will be
worth its intrinsic value (the difference between the puts’ strike prices) and the short puts will expire
at-the-money and worthless. The maximum profit amount may be calculated with the following formula:
Maximum profit =
(strike price differential x number of long puts) + net credit received (or net debit paid)
(Underlying at short strike at expiration)
Maximum Downside Loss

On the downside, since more puts are written than purchased the potential loss from the extra,
uncovered short puts is substantial, limited only by the underlying stock (or index) declining to no less
than zero. The more uncovered puts, the greater this loss can be.
Downside maximum loss = substantial
Upside Loss/Profit
If the spread was initially established at a net debit, this debit amount paid would be the limited upside
loss. If the spread was initially established at a net credit, this credit amount received would be the
limited upside profit. Either of these will be seen if the underlying stock (or index) closes at or above the
higher, long put strike price at expiration. If the spread was initially established for even money, there is
no upside profit or loss.
Upside = loss of debit paid or profit of credit received (Underlying at/above long strike at expiration)
Break-Even Point
The break-even point (BEP) for a ratio put spread at expiration will occur on the downside of the short
put strike price. It may be calculated in advance with the following formula:
Break-even point =
lower strike price – (points of maximum profit number of uncovered puts)

selling the long put(s) and buying the short put(s), and these closing trades may be executed
A decrease in volatility generally has a positive effect on a ratio put spread; an increase in volatility
Time decay generally has a positive effect on a ratio put spread because there are more short puts
than long ones. This is especially the case if the underlying stock (or index) stabilizes around the short
strike price as expected.
Ratio Put Spread - Continued

Example

1:2
Long 1 XYZ June 60 put
Short 2 XYZ June 55 puts
Maximum Profit
The maximum profit for this ratio put spread would occur if the underlying stock (or index) closed exactly
at the short put strike price of $55 at expiration. The long 60 put would have an intrinsic value of $5, and
the short 55 puts would expire at-the-money and with no value. This profit amount can be calculated in
advance according to the formula given earlier:
Maximum profit =
($5.00 strike difference x 1 long put) + 0 (credit/debit) = $5.00, or $500 total
Maximum Loss
On the downside, this 1:2 ratio put spread has one uncovered (naked) put contract. Because of this, the
potential loss is substantial, limited only by the underlying stock (or index) declining to no less than zero.
Maximum loss = substantial
Upside Profit/Loss
On the upside, this ratio put spread has no profit or loss potential because it was initially established for
even money.
Break-Even Point
At expiration, the break-even point for this ratio put spread would be a closing underlying stock price (or
index level) equal to $55 (lower strike price) – ($5.00 points of maximum profit 1 uncovered put) = $50.
BEP = $55 lower strike – ($5.00 maximum profit 1 uncovered put) = $50
XYZ June 60/55 Ratio Put Spread 1:2
Long 1 Short 2
Spread
XYZ Price 60 Put 55 Puts
Profit/Loss*
40 + $1600 – $2600 – $1000
42 + $1400 – $2200 – $800
44 + $1200 – $1800 – $600
46 + $1000 – $1400 – $400
48 + $800 – $1000 – $200
50 + $600 – $600 0
52 + $400 – $200 + $200
54 + $200 + $200 + $400
55 + $100 + $400 + $500
56 0 + $400 + $400
58 – $200 + $400 + $200
60 – $400 + $400 0
62 – $400 + $400 0
Assignment Risk
Equity Options
For an equity put option, early assignment generally occurs when the short put is deep in-the-money,
expiration is relatively near, and its premium has little or no time value. If a ratio put spread holder is
assigned early on short puts, then he may exercise as many long puts and to sell shares purchased via
the assignment obligation. If assigned on uncovered puts (i.e., more short puts than he is long) then he
must purchase underlying shares.
American-Style Index Options If early assignment is received on covered short puts of a ratio put
spread, the cash settlement procedure for index options will create a debit in the investor’s brokerage
account equal to the cash settlement amount. This cash amount is determined at the end of the day the
long put is exercised by its owner. After receiving assignment notification, usually the next business day,
when the investor exercises an equal number of long puts the cash settlement amount credited to his
account will be determined at the end of that day. There is a full day’s market risk if the long option is
not sold during the trading day assignment is received.
If assigned on uncovered short puts (i.e., more short puts than he is long), the cash settlement
procedure will create a debit in the investor’s brokerage account equal to the total cash settlement
amount.

Basics of Spreading: Ratio Spreads and Backspreads

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Basics of Spreading: Ratio Spreads and Backspreads

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Basics of Spreading: Ratio Spreads and Backspreads

What is a Spread? Download What is a Spread?

Terms & Characterizations: Part 2

Spread Order Execution

Calculating Profit & Loss

Early Assignment Risk

Profit limited & Loss limited

Profit not limited & Loss limited

Profit limited & Loss not limited

Call backspread = buy higher-strike calls + sell fewer lower-strike call(s)

Debit vs. Credit

Call backspread = debit, credit or even money spread

XYZ June 65/60 Call Backspread

XYZ June 65/60 Call Backspread

Motivation for Spreading

Risk vs. Reward

Maximum profit = unlimited

Downside = loss of debit paid or profit of credit received

Effect of Time Decay

Call Backspread - Continued

XYZ June 65/60 Call Backpread

Maximum profit = unlimited

XYZ June 65/60 Call Backpread 2:1

American-Style Index Options

Debit vs. Credit

Put backspread = debit, credit or even money spread

XYZ June 55/60 Put Backspread

XYZ June 55/60 Put Backspread

Put backspread: bearish

Motivation for Spreading

Risk vs. Reward

Maximum profit = substantial

Upside = loss of debit paid or profit of credit received

Effect of Time Decay

Put Backspread - Continued

XYZ June 55/60 Put Backpread

Maximum profit = substantial

XYZ June 55/60 Put Backpread 2:1

American-Style Index Options

Ratio Call Spread

Debit vs. Credit

Ratio call spread = debit, credit or even money spread

XYZ June 60/65 Ratio Call Spread

XYZ June 60/65 Ratio Call Spread

Ratio call spread: neutral to slightly bullish

Motivation for Spreading

Ratio call spread: profit from premium of written calls

Risk vs. Reward

Maximum loss = unlimited

Downside = loss of debit paid or profit of credit received

Profit & Loss Before Expiration

Effect of Time Decay

Ratio Call Spread - Continued

XYZ June 60/65 Ratio Call Spread

Maximum loss = unlimited

XYZ June 60/65 Ratio Call Spread 1:2

American-Style Index Options

Ratio Put Spread

Debit vs. Credit

Ratio put spread = debit, credit or even money spread

XYZ June 60/55 Ratio Put Spread

XYZ June 60/55 Ratio Put Spread

Ratio put spread: neutral to slightly bearish