Ratio spreads

Abstract

Ratio spreads in which one buys X calls (or puts) at one strike and sells Y calls (puts) at a different strike where YX are among the most actively traded option combinations yet are only briefly mentioned in most derivatives texts and have received no attention in the research literature. Moreover when ratio spreads are discussed in texts or the practitioner literature the proposed uses vary widely. There is no agreement on when these spreads should be used, no guidance on how they should be designed, and no data on how they are used and designed. Based on data on ratio spread trades from the Eurodollar options market, we examine the design of ratio spreads and explore what the chosen designs reveal about the motives of the traders. We find that most ratio spreads are designed so that the net price is positive but small and most have small deltas. The data is mixed on whether ratio spreads are used as volatility spreads. Their gammas and vegas have the hypothesized signs but are generally quite low. Frontspread designs in which profits are bounded and losses unbounded considerably exceed backspread designs in which losses are bounded and profits unbounded.