Diagonal Ratio Spreads are simply Diagonal spreads that buy and sell an unequal number of options. What Diagonal ratio spreads do is essentially to combine the directional and calendar merit of Diagonal spreads with the neutral or volatile inclination of ratio spreads, creating unique neutral and volatile options trading strategies that allows maximum profit or unlimited profit in one direction while establishing the Diagonal ratio spread positions with a net credit. Being a credit spread puts time decay in your favor, thereby greatly reduces risk and increases the probability of win. This tutorial shall explain what Diagonal ratio spreads are in options trading and outline all of the different kinds of Diagonal ratio spread options strategies.
To understand what Diagonal ratio spreads are, you need to first learn about
Diagonal spreads and
ratio spreads. Go do that now.
Diagonal Ratio Spreads are Diagonal spreads that buy and sell an unequal number of options. In classic Diagonal spreads, you will always buy and sell an equal number of options on each leg. For example, in a
Calendar call spread, you will short as many
near term out of the money call options as the longer term
at the money or
in the money call options bought. However, in a Diagonal ratio spread, you would short more out of the money call options than the
call options that are bought. The term "Ratio" in Diagonal Ratio Spreads refers to the fact that the number of contracts on each leg conforms to a certain ratio. The most common ratio in Diagonal Ratio Spreads is having 2 short options to 1 long option, what we call a 2:1 ratio spread.
Diagonal Ratio spread is simply a way of classifying Diagonal spreads that buys and sells an unequal number of contracts simultaneously. Knowing or not knowing such classification does not actually affect your options trading in anyway as long as you are familiar with the specific options trading strategy that you are using.
Advantage of Diagonal Ratio Spreads Against Vertical Ratio Spreads
Comparing with Vertical Ratio Spreads, Diagonal Ratio Spreads are simply vertical ratio spreads that buys further expiration call options.
Buy To Open 1 Jan50Call and
Sell To Open 2 Jan55Call is an example of a Vertical Ratio Spread. To transform it into a Diagonal Ratio Spread,
you simply need to Buy To Open 1 Mar 50Call and Sell To Open 2 Jan55Call. By buying a further month call option than the call options
that are shorted, a vertical ratio spread is transformed into a Diagonal Ratio Spread. Such is the flexibility of options trading.
So, what's the advantage of doing that?
The main advantage of Diagonal Ratio Spreads against the Vertical Ratio Spread is the fact that you could short near term call options against the
longer term options for more than one month, thereby saving commissions and extending profits. This is a clear advantage when the underlying stock is
expected to behave in a certain fashion for more than one month. Of course, when you get to the final month, the Diagonal Ratio Spread gets
transformed back into a Vertical Ratio Spread as the same month options are shorted against the long options.
Types of Diagonal Ratio Spreads
Essentially, all Diagonal spreads can be converted into Diagonal ratio spreads just by buying and shorting an unequal number of options on each leg. It is one of the things that gave options trading its unique flexibility. There are 2 broad types of Diagonal ratio spreads; Call Diagonal Ratio Spreads and Put Diagonal Ratio Spreads.
Call Diagonal Ratio Spreads are diagonal ratio spreads made up of only call options.
Call Diagonal Ratio Spreads involve selling more out of the money call options than at the money / in the money call options are bought so as to create a position that profits all 3 ways with maximum profit attained when the stock goes up.
Call Diagonal Ratio Backspreads involve buying more at the money or out of the money call options than in the money call options are bought in order to create a
credit volatile options trading strategy with unlimited profit potential to upside. Typical credit
volatile options strategies does not come with unlimited profit potential either way.
Put Diagonal Ratio Spreads are diagonal ratio spreads made up of only put options.
Put Diagonal Ratio Spreads involve selling more out of the money put options than at the money / in the money put options are bought so as to create a position that profits all 3 ways with maximum profit attained when the stock goes down.
Put Diagonal Ratio Backspreads involve buying more at the money or out of the money put options than in the money put options are bought in order to create a credit volatile options strategy with unlimited profit potential to downside.
The basic aim of Diagonal Ratio Spreads is to create credit volatile options strategies with unlimited profit potential in one direction and also to create positions that profit in all 3 ways.
Typically, volatile options strategies put on for a net credit, like the
Short Butterfly Spread, only has limited profit potential. This means that no matter how far the underlying stock breaks out to either direction, there is a limit to the maximum profit attainable. However, Diagonal Ratio Spreads overcome that limited maximum profit potential weakness of credit volatile options trading strategies by introducing unlimited profit potential in one direction and limited profit in the other direction, opening up direction for explosive profit should the underlying stock moves strongly in that direction. Taking the Call Diagonal Ratio Backspread for example, if the underlying stock breaks to downside, it makes a limited profit just like the Short Butterfly Spread but if the stock breaks out to upside and continues going upwards strongly, the Call Ratio Backspread makes an unlimited profit as long as the stock continues to go up!
Diagonal Ratio Spreads also overcomes the single directional weakness of Diagonal spreads by allowing them to profit even when the stock remain stagnant or goes in the disfavorable direction! Unlike typical Diagonal Spreads such as the Diagonal Calendar Call Spread which makes a loss when the stock goes down, its Diagonal Ratio Spread equivalent, the
Call Diagonal Ratio Spread, makes a profit even if the stock goes down strongly!
More options trading profit, more directions and more possibilities than typical non ratio spreads is what Diagonal ratio spreads are capable of.
Advantages of Diagonal Ratio Spreads
Lowering of margin requirement when shorting near term options.
Capable of profiting in all 3 directions.
Creates the only credit volatile options trading strategy that has unlimited profit potential in one direction.
Unlike Vertical Ratio Spreads, Diagonal Ratio Spreads are capable of profiting for more than one month.
Disadvantages of Diagonal Ratio Spreads
Margin is needed when shorting more options than options of the same type are bought.
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Diagonal Ratio spread is simply a way of classifying Diagonal spreads that buys and sells an unequal number of contracts simultaneously. Knowing or not knowing such classification does not actually affect your options trading in anyway as long as you are familiar with the specific options trading strategy that you are using.
