According to SEBI, only 7% of F&O traders in India made profits in the past three years. This raises concerns about what is wrong with the other 97%. In most cases, the primary reason behind these losses is the lack of proper strategy. This is where things like ratio spread strategies can become a game-changer for Indian options traders.      

A ratio spread is a trading strategy in which investors hold short and long options. However, these options need not be equal in value or number. Most investors use this tactic when it is likely that the asset’s price won’t see any considerable change. For instance, if the investor is bearish, they will use the put ratio spread, but bullish investors will leverage the call patio spread. Investors also can change the 2:1 ratio based on their needs.     The growing interest in the derivatives market in India is fueling the popularity of the ratio spread strategy in the country. Indian investors are also more interested in hedging opportunities and a more sophisticated approach to trading. These factors are making ratio spread strategies a big hit in this sector. However, ratio spreads have been popular in the derivatives market for many years. This strategy offers better potential returns and greater flexibility, making it a choice for many. Besides, the fact that you don’t need much capital for this strategy is another factor that makes it popular with many.      

Components of a Ratio Spread

When devising the proper ratio spread option strategy, there are two primary options in front of you. 

• Call Option: The first is the call option, which investors can buy either out-of-the-money (OTM) or one-in-the-money (ITM). While they buy this, they must also sell or write two higher-stake OTM call options. When the underlying asset’s price rises significantly, the trader incurs more loss. This happens because they have sold more positions than they have long.        
• Put Ratio Spread: The other is the put ratio spread, where investors can buy one OTM or ITM put option and sell or write two other OTMs with lower stakes. In this case, the investor will incur a loss when the underlying asset’s price moves downward. This happened because the traders sold more than they had been long.    

In this case, the call spread ratio refers to the proportion of options you buy to the ones you sell. For instance, if you have a ratio of 1:2, it will indicate you bought 1 option and sold 2 options. Similarly, if the ratio is 1:3, it will indicate you are buying 1 option and selling three options. 

• Spread: The next thing here is spreads, which are two different types. The first is the net debit spread, in which investors must pay a net premium to establish a position. Besides that, we have the net credit spread, in which the investor will receive a net premium from establishing a specific position.     

Types of Ratio Spreads

If you want to make the most of the ratio spread strategy, you must familiarise yourself with different types of these spreads. So, let’s take a closer look at each of these types and help you choose the one that best caters to your needs:

1. Bull Call Ratio Spread

The bull call ratio spread means the investor starts by buying several call options. Then, they sell an even larger number of these options at a higher strike price for a significant return. However, this return will only become a reality if the prices of the underlying asset rise. This makes the bill call ratio spread the perfect fit for bullish market conditions.     

2. Bear Put Ratio Spread

The next type of ratio spread here is the bear put ratio spread. Here, you must buy a certain number of put options. Then, you must sell even a larger number of these options at a lower strike price. If there is a decline in the underlying asset’s price, you get great returns. This makes the bull put ratio spread the ideal and highly effective approach in bearish markets.    

3. Neutral Ratio Spread

The third and final type is the neutral ratio spread, where you can profit from both calls and put options. This strategy allows you to profit from the slightest price movements of the underlying asset. Most investors leverage this strategy in market-neutral outlooks to maximise every little price fluctuation.    

Advantages and Disadvantages 

It is clear by now that ratio spread strategies can be highly effective when used properly. But before you jump to conclusions about these strategies, you must understand their shortcomings and perks.  

1. Advantages 

Here are some of the best-known advantages of using the ratio spread strategy for options trading:

2. Disadvantages 

Just as there are advantages, the ratio spread approach also comes with certain shortcomings that include:

3. Balancing Risks and Rewards 

While there are always risks that come with ratio spread strategies, there are also rewards that can help grow your wealth. The trick is to strike the right balance between these risks and rewards to drive better profitability. Hence, here are some tips to help you strike that balance:  

• Proper Position Sizing: Proper position sizing is one of the most effective ways to balance risk and rewards with a ratio spread. This means that you must avoid overtrading and allocate capital wisely to get better returns. 
• Research: When it comes to options trading, research is the most effective tool you can ask for. If you use the ratio spread strategy, analyse market trends, underlying assets, and overall market volatility.  
• Monitor Regularly: Another simple but effective thing you can do here is monitor the position’s performance regularly. You must also make necessary adjustments whenever possible to avoid losses and increase returns.     

How to Implement a Ratio Spread in India

Implementing ratio spread in India is not as challenging as you might think, but only if you follow the right steps. So, let’s take a look at each of these steps for a better idea:

Step 1: Choosing the Right Underlying Asset   

Only 1% of individual traders make a profit of more than Rs. 1 lakh with F&O trading. One primary reason behind this is the failure to choose the right underlying asset. Traders must consider liquidity and choose assets with higher trading volumes to ensure seamless entry and exit. They must also consider the asset’s historical and expected future volatility to make an informed choice.    

Step 2: Selecting Strike Prices and Expiry Dates

The next thing to do here is to put more effort into selecting the right strike price and expiry date. You must choose prices and dates that reflect your outlook on the market and not any other factor. You must also factor in the time value of options to choose expiry dates that work to your advantage.    

Step 3: Calculating Costs and Potential Outcomes

The final step is to calculate costs and potential outcomes before making any move. You must use options pricing models or market data to estimate the proper cost of the spread. Then, you must determine specific zones for profit and losses at different levels of the underlying asset. This will ensure you are not under 91.5% of options traders who lose money.   

Regulatory and Taxation Considerations in India 

It is no secret that there are certain rules and regulations when it comes to options trading in India. The Indian government has these laws in place to safeguard the interests of traders and investors. So, let’s take a look at these laws for a better understanding:

1. SEBI Regulations  

SEBI recently developed new rules and guidelines for options trading in the country. Some of the best-known of these regulations include:

• Reduction in Weekly Expiries: As per the new SEBI rules, weekly options contracts will be reduced. From now on, exchanges will only offer one weekly index derivative contract. 
• Extreme Loss Margin: New rules apply an Extreme Loss Margin (ELM) of 2% to short index options contracts to limit market volatility and reduce risk appetite.        
• Upfront Premium Collection: SEBI has now made it mandatory for brokers to charge an upfront option premium from traders.

2. Tax Implications 

Section 43(5) of the Income Tax Act states that every profit and loss from options trading falls under non-speculative business income. You must declare these losses and profits from options trading under the head Profit and Gain from Business and Profession (PGBP). Besides, any income from options trading falls under the business income category. If you are involved in these trades, you must file these profits and losses using the ITR-3 form. This form is specially designed for taxpayers with PGBP Income.       

3. Brokerage and Margins 

There are different brokerage and margins for options trading with ratio spreads. It is up to you to research and check what different brokerage platforms and services offer. This will help you better understand your needs and risk appetite so that you can make an informed choice.    

Common Misconceptions About Ratio Spreads 

Misconceptions are the worst enemies of any options traders, even more so if they use the ratio spreads strategy. Hence, you must understand these misconceptions and avoid them.  

Case Study Exploring the Use of Ratio Spread Strategy in Options Trading in India 

Check out the following case study to better understand how the ratio spread strategy works in options trading: 

Background: 

Let’s say the Nifty 50 index is currently 12,000, and a trader thinks it will increase slightly in the upcoming month. In this case, they are most likely to set up a call ratio spread that looks like this:

Strategy:

• Buy one lot of the Nifty 12,100 call option for Rs.200 per share. 
• Sell two Nifty 12,200 call option slots for Rs.120 per share.   

Results: 

Here, each Nifty lot had fifty shares. This way, the total pay for the long call will be Rs. 10,000 (200×50). When the trader sells the two short calls, they will get Rs.12,000 (120x2x50). This means the trader will get a net credit of Rs.2000 (12,000-10,000). The maximum profit they can earn here is Rs.12,000, but the potential for loss is also considerable. 

Tips for Using Ratio Spreads Effectively

The ratio spread option strategy is an effective tool for options traders, and here are some effective tips to help you make the most of this approach:   

• Identifying the Right Market Conditions: The ratio spreads strategy is important only when market conditions align with it. 
• Risk Management: Never underestimate the importance of risk management. Implement stop-loss orders and monitor positions very closely.  
• Adjustments and Monitoring: As you monitor the positions, always make the necessary adjustments to increase the chances of profits.    

Key Takeaways 

Ratio spreads for options trading are complex and require much planning and careful execution. However, it is also true that they offer a better potential for greater returns and limited losses. While these returns are impressive, you must also deal with the inherent risks of these investments. This is why you need thorough research, effective risk management, and continuous learning for better chances of success.