The ratio-spread is a name given to a strategy in options trading and that strategy involves buying some number of options and selling a larger number of other options of the same underlying market and (usually) the same expiration date, but of a different strike price.

The ideal situation when this strategy should be used is when either :

A) the implied volatility of the options that are expiring in a particular month has recently shown a sharp higher movement and is now beginning to decline, or

B) it is anticipated by the trader for whatever reason that during the life of the option the underlying market of the option(s) will move steadily in his favor.

Call options are used by the trader in this strategy if he believes the underlying market will move steadily higher, and put options is used by him if he believes the market will move steadily lower.

In the case of call options, some number of options having striking price X will be bought by the trader and the trader would sell (write) a larger number of options that are having striking price Y, where Y is greater than X. In the case of put options, some number of options having striking price A would be bought by the trader, but he will write (sell) a larger number of options having striking price B, where B is less than A.

This strategy is described by the “straight” ratio-spread if the trader buys and writes (sells) options having the same expiration. If, instead of doing that, the trader executes this strategy by buying options that have expiration in one month but writing (selling) options that have expiration in a different month, then this is referred to as a ratio-diagonal trade.

As with all option spreads, the trader in a ratio-spread will give a strong preference to buy those options that have distinctly lower implied volatility than the options that he is writing (selling).

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