Ratio Spread Definition

Option ratios

In short, option volume is the number of contracts traded in a security or an entire market during a specific time frame, usually one trading day.

A ratio spread is a neutral options strategy in which an investor simultaneously holds an unequal number of long and short or written options. The name comes from the structure of the trade where the number of short positions to long positions has a specific ratio. The most common ratio is two to one, option ratios there are twice as many short positions as long. Conceptually, this is similar to a spread strategy in that there are short and long positions of the same options type put or call on the same underlying asset.

It is simply the amount of options that change hands from sellers to buyers as a measure of activity. If a buyer purchases contracts from a seller or a market maker, then the volume for that period increases by contracts based on that transaction.

Let's look at another example.

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XYZ at the October 30 strike. On the same day, Bill buys option ratios for the same strike and month.

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This result would hold true regardless of option ratios the XYZ calls were bought or sold by either Jim or Bill. As you can see, option volume indicates the number of contracts traded at a particular strike for a particular option for a specified time frame. Option volume is a useful tool for traders, as it can point out where traders are option ratios their attention on an intraday basis.

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For instance, assume that XYZ Inc. High call option volume could be the result of such an occurrence, as options traders try to take advantage of the underlying stock's move higher.

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Vice versa, a negative reaction to the same report could bring about a spike in put option volume. However, if you did not know that XYZ Inc.

As such, option volume can be an handy indicator for events known or unknown surrounding a particular stock. Where open interest indicates the actual number of puts or calls in residence at a particular strike or for a particular period of options, volume is merely the number of contracts changing hands.

Learn Sentiment Trade Drivers Option Volume & Put-Call Ratio

Just because option volume spikes at a particular strike, does not mean that open interest will increase or decrease. For example, let's return to the calls that were traded on XYZ Inc.

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Let's say that this particular strike already has open interest of contracts. Without knowing whether or not this option volume was bought to open or sold to close, we do not option ratios if open interest at XYZ's October 30 strike will increase or decrease, or if it will change at all.

Ratio Spread

If the calls were bought to open, then we could see open interest increase to contracts. Meanwhile, if these calls were sold to close, then we could see open interest decline to zero. Furthermore, if these contracts were merely changing ownership, we could see no change in open interest at all.

To arrive at this figure, the put volume is divided by call volume.

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Such ratios are calculated on individual stocks, indices, or the overall market. Looking at our example on XYZ Inc. The closer this ratio moves to 1.

There is no limit to the maximum possible loss when implementing the call ratio spread strategy. There may even be a profit if a credit is received when putting on the spread. Breakeven Point s There are 2 break-even points for the ratio spread position. The breakeven points can be calculated using the following formulae. However, there is no downside risk to this trade.

Such a development can be seen as a contrarian indicator of excessive pessimism, and can hint at a potential bottom, or rebound, in the underlying stock or index.

The inverse can also be seen as a contrarian indicator for a potential top, or roll over, in the underlying stock or index.