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How A Put Ratio Spread Works And Why Microsoft Is A Candidate

How A Put Ratio Spread Works And Why Microsoft Is A Candidate

The market seems like it could go either way at this point, so it’s nice to have a flexible option strategy that profits in multiple scenarios. That’s the idea behind this put ratio spread on MSFT stock. Put ratio spreads are an advanced option trade and not generally suitable for beginners, but they can have their place within an option portfolio.




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Put Ratio Spread On MSFT Stock

As opposed to a regular vertical spread where there are an even number of contracts sold and bought, the put ratio spread has an asymmetry to it. The strategy involves buying a put option and selling two put options further out-of-the-money. It’s like you have a bear put spread with one extra short put.

Here’s how you could set one up with Microsoft (MSFT):

  • Sell to open two MSFT stock Nov. 17 puts with a strike price of 310. They traded recently around 3.55.
  • Buy to open one MSFT stock Nov. 17 put with a strike price of 320. The price was around 5.80.

As we are selling two contracts at $3.60, the trade results in a net credit of $1.30.

Why A Put Ratio?

The put ratio strategy is generally considered a slightly bullish strategy. But it has the ability to potentially make a profit in up, down and sideways markets.

Yes, it can make money no matter which way the market goes — the key is the timing!

The trade is placed when the trader thinks the underlying stock will be stable. MSFT stock fits the bill since it’s been in a trading range since July.

Ideally, you don’t want to see MSFT stock drop below the short put strike of 310 at expiry. That nearly matches it’s August and September lows.

A fall in implied volatility for MSFT stock will benefit the trade. The trade also can be profitable if MSFT stock moves up early in the trade.

The main risk with the trade is a sharp move lower for MSFT stock early in the trade.

Profit And Loss Areas

If MSFT stock finishes above 320 at expiration, all the puts expire worthless and you keep the $130 premium for the spread.

A tent-shaped profit zone exists between 300 and 320, with the maximum gain occurring at 310. In this case, the short puts expire worthless. But you have 10 points of value on your long put plus the credit received. If MSFT stock closes right at 310 at expiration, the profit is around $1,130.

As for a loss, the losses in the short puts cancel out the gains of the long put at 300. Once you’ve exhausted the premium received, you incur losses below the break-even price of 298.70 for MSFT stock. At that point, it’s like you have a single short put.

In the unlikely event that MSFT stock went to zero, you could lose $29,870, just like when you own the stock. Of course, most traders would exit the position long before then.

As the trade involves that naked option, it is not recommended for beginners.

In terms of a stop loss, I would close the trade if it was down $400.

This strategy should move fairly slowly unless there is a sharp drop in the stock price. The trade starts with a delta of 10, which means it is roughly equivalent to owning 10 shares of MSFT stock, although this will change as the trade progresses.

According to the IBD Stock Checkup, MSFT stock is ranked No. 2 in its industry group and has a Composite Rating of 97, an EPS Rating of 96 and a Relative Strength Rating of 91.

It’s worth noting that this put ratio spread on Mastercard (MA) worked well and can be closed.

Please remember that options are risky, and investors can lose 100% of their investment.

This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.

Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ

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