Ratio spreads

Definition

A ratio spread holds unequal numbers of long and short options at different strikes, same type and expiry — most commonly one long near-the-money option against two short further-OTM options (“1x2”). Sold-heavy ratios collect premium and carry UNDEFINED risk beyond the short strikes; bought-heavy ratios are the reverse and have their own entry (strategy-backspread). This entry covers the sold-heavy (front) ratio.

How it works / structure

• Legs (call 1x2 example): +1 call K1, −2 calls K2 (K2 > K1), same expiry; often entered at zero cost or a small credit.
• Payoff at expiry: below K1, keep the net credit (or lose the small debit); maximum profit at K2 = (K2 − K1) + net credit; above K2 + width + credit, losses grow without bound — the structure is net short one naked option beyond K2. Put 1x2s mirror this below the market.
• Parameters (engine-executable): ratio (1x2, 2x3), strike gap, net-cost target, expiry, IV/skew gate (iv_rank; put ratios monetize the smirk’s rich low wing — opt-volatility-skew), management (mgmt-stop-loss on the underlying breaching the short strike zone, mgmt-rolling, or conversion to a defined structure by buying a wing — becoming strategy-broken-wing-butterfly).
• Greeks profile: path-dependent — the position flips from long delta / long gamma near K1 to violently short both beyond K2 as expiry approaches (greek-gamma).

When it applies

“Moves toward but not through” theses — a target zone at K2 with conviction the move stalls there; skew-monetizing entries where the two short wings are priced rich; repair/adjustment contexts (overlaying a ratio to move a losing position’s breakeven). The undefined tail makes sizing and scenario analysis (risk-scenario-analysis) load-bearing.

Risk profile & failure modes

• The thesis’s own success is the hazard: the structure makes maximum money at the short strike and unbounded losses past it — being MORE right than planned is the loss case (the inverse of most spreads); event gaps through K2 are the realized disaster mode.
• Late nonlinearity: near expiry the P&L cliff beyond K2 steepens; positions held into the final week convert a management problem into a gamma problem.
• Margin expansion: the embedded naked short means stress margin grows exactly as the position sours (acct-margin-rules).
• Adjustment debt: “rolling the tested side” of ratios accumulates short options; unmanaged adjustment chains grow the tail rather than closing it.

Evidence & limits

Mechanics are contract arithmetic (OCC/Cboe). No public study establishes ratio spreads as an excess-return class; the skew premium they monetize is measured (opt-volatility-skew citations) but its harvest via undefined-risk structures is a sizing question the platform grades per replay. “Zero-cost so nothing to lose” is folklore — the cost is the open tail.

Falsifiable-thesis examples

Illustrations only, not signals:

• “X will finish the cycle between K1 and K2 (max-profit zone)” — falsified by a finish outside it.
• “X will not trade beyond K2 + width at any point before expiry” — falsified by any print past that level.

Cross-references

• Mirror image: strategy-backspread; defined-risk conversion: strategy-broken-wing-butterfly
• Pricing source: opt-volatility-skew, opt-iv-rank-percentile
• Danger mechanics: greek-gamma, ms-expiration-exercise-assignment, acct-margin-rules
• Containment: mgmt-stop-loss, risk-scenario-analysis, risk-fixed-fractional