How to Generate A Consistent Income With The Put Ratio Spread

The Put Ratio Spread is by far one of the best strategies, if not the best Option strategy to generate a consistent income.

That’s because it has an extremely high win rate of at least 80%…

It has a huge profit potential…

And it’s a great hedge to any Long stock position you have on because you actually make more when the market goes down.

And even if the market shoots to the moon, you have absolutely no risk to the upside.

That is why the Put Ratio Spread is one of my favorite strategies to trade.

However, it is an undefined-risk strategy.

That means that theoretically, you could lose a lot of money if you don’t trade it the right way.

But when traded correctly, the Put Ratio Spread can be a very profitable strategy:

So how exactly do you trade the Put Ratio Spread safely and profitably to generate a consistent income?

What Is The Put Ratio Spread

The Put Ratio Spread is an omnidirectional trading strategy.

That means it can be tweaked to profit in any direction you want.

It is the combination of two strategies:

• Bear Put Spread (aka Put Debit Spread)
• Short Put

On the chart, it will look something like this:

If you noticed, the Short leg of the Bear Put Spread is at the same strike as the Short Put.

That’s usually how the Put Ratio Spread is constructed, but you could also place the Short Put at a lower strike price.

It’s a very versatile strategy where you can play around with the strikes.

It’s also a unique strategy because it combines two opposing strategies together.

The Short Put is a neutral to bullish strategy, whereas the Bear Put Spread is a bearish strategy.

Also, the Short Put is a premium-selling strategy, whereas the Bear Put Spread is a premium-buying strategy.

But overall, the Put Ratio Spread is a premium-selling strategy because we want the credit received from selling the Short Put to be more than the debit paid for buying the Bear Put Spread.

The idea here is to use the credit received from selling the Short Put to purchase the Bear Put Spread.

So if we received $2.44 for selling the Short Put, we want to buy the Bear Put Spread for less than that.

In the image above, you can see that the Bear Put Spread was bought for $2.18 resulting in an overall $0.26 credit.

So per Put Ratio Spread, you would receive $26 in premium.

The Put Ratio Spread Risk Profile

When you put these two strategies, you get this risk profile graph:

This is a 45 DTE Put Ratio Spread.

In general, when we put on any Option strategy, we want the expiration to be somewhere from 40 DTE to 60 DTE.

The first thing that you will notice is that there is no risk to the upside.

That’s because the credit received from the Short Put is greater than the debit paid for the Bear Put Spread.

If however, the credit received from the Short Put is lesser than the debit paid for the Bear Put Spread, then there will be risk to the upside.

So it’s important to structure the Put Ratio Spread for an overall credit so you do not have any risk to the upside.

Next, you will notice that there is this “tent” shape towards the left-hand side of the risk profile.

If the market settles exactly at the Short strikes at expiration, this is where you will make the most profit.

That is why it is a good hedge for a Long stock portfolio because if the market drops, you can profit on your Put Ratio Spread.

But if the market goes up, you will make the credit received for the Put Ratio Spread and from your Long stock portfolio.

It’s a win-win situation both ways.

However, there’s still risk to the downside of the Put Ratio Spread.

If the market goes too far down below the breakeven point, that’s when it will start losing money.

But not to worry, because that doesn’t happen as often as you think it might.

That’s because the breakeven point is below the one standard deviation point.

Most of the time, the market will stay within the one standard deviation range (aka Expected Move).

And the times when it exceeds the breakeven point, your loss will rarely exceed the Buying Power Requirement (BPR) of the trade.

So you know that your worst possible loss would be contained within the BPR, which should account for only a maximum of 5% of your capital.

The above shows the visual representation of the P&L profile on the chart.

As you can see, if the market is above the Long Put strike, you just keep the premium.

If the market goes below the Long Put strike, that’s where you will start to make more with the maximum profit at the Short strikes.

Then once it goes past the Short strikes, the profit gets lesser until it goes past the breakeven point where you will begin to lose money.

The Put Ratio Spread Is A “Slow” Strategy

Because of the embedded Bear Put Spread, the Put Ratio Spread is a slow-moving strategy where you’re not able to realize the max profit of the “tent” until expiration day.

For example, if the market goes down to the Short strike a few days after you put the trade on, you would very likely see a loss instead of a profit.

In the risk profile above, you will see a purple line and a green line.

The purple line is the current P&L.

The green line is the P&L at expiration.

As it reaches expiration, the purple line will gradually move up to conform to the green line.

The image above is the Put Ratio Spread at 7 DTE.

By this time, you’ve probably held on to the spread for about 5 – 6 weeks and the profits at the “tent” is not even at 50% of the max profit.

Even at 1 DTE the P&L at the “tent” is slightly past the 50% mark.

That’s why this is a very slow-moving spread where you must hold it till expiration to realize the max profit potential of this strategy.

But if you hold till expiration, there’s the risk of early assignment if the Short strikes are In-the-Money (ITM).

And if at expiration your strikes are ITM, you will get assigned.

So what can we do to circumvent this?

By trading it on cash-settled Index products like the following:

• MRUT (mini Russell 2000 Index Options)
• RUT (regular-sized Russell 200 Index Options)
• XSP (mini S&P 500 Index Options)
• SPX (regular-size S&P 500 Index Options)
• NDX (regular-size Nasdaq Index Options)

Most of the stocks and Index ETFs are using American-style Options where the buyer of the Options can exercise at any time prior to expiration.

However, the four products mentioned above use European-style Options which can only be exercised at expiration.

This way there’s no risk of early assignment.

And because it’s cash-settled, there’s no assignment of shares/ETFs.

Instead, you will just realize any profit or loss in cash.

So you don’t have to worry about suddenly getting Long/Short shares and not having enough funds in your account to fulfill the obligation.

Therefore if you want to trade the Put Ratio Spread without the fear of getting assigned, then you want to only trade on cash-settled products.

How To Trade The Put Ratio Spread

Here are the trade mechanics for trading the Put Ratio Spread:

• Nearest to 45 DTE.
• Around 15 – 20 deltas for the Short Put.
• Bear Put Spread construction:
  • If more bullish, construct a smaller width with a smaller debit.
    • Long Put strike closer to At-the-Money (ATM).
  • If more bearish, construct a larger width with a larger debit.
    • Long Put strike more Out-of-the-Money (OTM).

Watch the 2-part video on the Put Ratio Spread here: