38 Pages Posted: 22 Jan 2008
Ratio spreads in which a trader buys calls (or puts) at one strike and sells an unequal number of calls at a different strike 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. In texts and other discussions of option spreads and combinations, there is no agreement on when ratio spreads should be used, little guidance on how they should be designed, and no data on how they are actually used and designed. Seeking to fill this gap, we discuss the properties of ratio spreads and document their design and use in the Eurodollar options market. Exploring what the chosen designs reveal about the motives of the traders, we find that most ratio spreads are designed to have low cost and to be roughly, but not completely, delta neutral. Front-spread designs in which profits are bounded and losses unbounded considerably exceed back-spread designs in which losses are bounded and profits unbounded. Results are mixed on whether ratio spreads are primarily used to exploit expected changes in volatility since while designed so that vega has the hypothesized sign, vega values are generally smaller than could have been achieved with a slightly different design.
Keywords: Ratio Spreads, option spreads, option trading
JEL Classification: G13
Suggested Citation: Suggested Citation