Crypto Options Trading 1×3 Ratio Spreads: Unlock Profits in Low Implied Volatility Markets

If you’d like to learn more about this strategy and see it in action, check out this YouTube video with Deribit Live where we go into a more in-depth discussion on the topic.

Regardless of the strategy, most retail crypto options traders make (and sometimes lose) most of their money in higher volatility markets, where they are primarily seeking opportunities to profit from price movements where they're long volatility. Let’s face it, when one thinks of crypto options trading, high Implied Volatility (IV) is where traders find most of the allure, excitement, and action.

We do things a little differently than the typical retail trading crowd largely because we’re option sellers about 90% of the time, so we love the premiums that high volatility provide (sell high, buy low), using them to earn consistent monthly income. When volatility drops off, however, we need to make adjustments and find ways to continue generating profits.

The reality of trading is that low volatility and flat markets happen, sometimes persisting for extended periods of time.

These markets require a different or at the very least, an adjusted approach.

Too many traders do not adjust their strategies, position sizing, or expectations during these periods. Pushing high IV strategies will simply not work or have very muted results in low IV markets, and can sometimes lead to significant losses.

Understanding Implied Volatility in Crypto Options Trading

Before getting into the details of how we use 1 x 3 ratio spreads, let’s first understand the significance of implied volatility in options trading. Implied volatility represents the market’s expectations of future price fluctuations of an underlying asset, overall market, etc. When implied volatility is low, it suggests that traders anticipate minimal price movements in the near term.

On the other hand, as you’d expect, high implied volatility indicates expectations of larger price swings. One can also think of it as a fear indicator. When the fear is high, a trader selling options is going to expect a higher premium for selling the option in order to assume that risk.

Implied volatility is a major component in determining options prices so, in low implied volatility markets, options premiums are relatively cheap, as there’s less uncertainty priced into them. For option sellers this poses a potential problem with the sell high, buy low strategy because it’s no fun selling low and buying high, which can happen if volatility increases after an option has been sold.

Conventional wisdom dictates that when implied volatility is low, buy it, then wait for the inevitable expansion. Great idea, but without knowing when the implied volatility will expand, a trader can spend significant sums of money “betting” on the expansion that doesn’t materialize. By the time IV does begin to expand, many traders are out of money or have been extremely frustrated and are reluctant to jump in and get burned again.

Crypto options trading is notorious for its high IV, yet here we are… in a low IV environment where it can be dangerous to sell, and buying requires a trader to be right on the timing and direction of an asset. A difficult situation for sure. Most retail traders in hindsight after not changing their approach and attempting to use the same strategies used in high IV markets, often realize that sitting on the sidelines would have been the best course of action.

However, professional traders don’t usually have the option of waiting weeks, months, or possibly longer for IV to expand.

Luckily, over the decades that we’ve been trading, there are a handful of go-to strategies we’ll deploy in these markets when opportunities present themselves, and the 1 x 3 ratio spread is one of them.

What is a 1x3 ratio spread?

A 1 x 3 option ratio spread is a multi-leg options strategy that involves the combination of long and short positions on the same underlying asset using different strike prices. This strategy is a limited profit, unlimited risk strategy basically designed to capitalize on smaller price movements while mitigating the cost of doing so.

The components of a 1x3 option ratio spread:

Long option: A trader buys a single long option, serving as the anchor of the strategy because this is the directional bet we’re hoping for. The option can be in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM), but most often when we use this strategy the option will be ATM or close to.

Short options (3): The trader simultaneously sells 3 short options with the same expiration date as the long option. While there’s flexibility on how many short options to sell, we often use 3 for reasons detailed below. The short options are OTM and can have the same or different strike prices, but we generally use the same strike price for all three of the short options.

Bullish 1x3 call ratio spread

A bullish 1x3 call ratio spread involves buying one ATM (typically) call option and simultaneously selling three OTM call options. The sold (or short) calls have a higher strike price than the purchased (long) call.

Bearish 1x3 put ratio spread

Conversely, a bearish 1x3 put ratio spread entails buying one ATM put option and simultaneously selling three OTM put options with a lower strike price.

The mechanics of the 1x3 ratio spread

When we use a 1x3 strategy, we’re looking for the underlying assets price to move in the direction of the long option, but because we’re deploying this in a low IV, “flat” market, we don’t expect the price to move too far, and not beyond our short strikes.

We are particularly fond of this trade during these conditions because the premium received from selling short options will offset most if not all of the cost of the long option. In fact, more often than not, when we use this strategy, the short options premium is more than the cost of the long option, meaning that we collect money up front for putting the position on.

As mentioned earlier, while buying options during low IV markets is theoretically the correct play, the trader must be correct on both timing and direction. If a low IV market persists, and the trader continually bets on IV expansion with no payoff, it can get very expensive. We eliminate this by using the 1x3 because we’re usually getting paid to put the strategy on.

The ideal scenario for this strategy when crypto options trading:

1. Volatility remains low or shrinks
2. The price of the underlying asset will move in favour of the long option
3. The price of the underlying will expire at, or just below the short strike prices (note that we very rarely hold an option to expiry).

Because we’re normally collecting a credit in the form of a premium, If the directional “bet” is wrong and the underlying assets price moves very little or even moves in the opposite direction of the long option, we keep all the premium.

Risk management and potential downsides

While the 1x3 option ratio spread offers an attractive risk-reward profile in low IV markets, it is essential to understand the potential downsides and practice prudent risk management.

Limited profit potential: One of the primary limitations of this strategy is that it has a capped profit potential. The maximum profit occurs when the underlying asset’s price moves to, but not beyond the short strike price.

Unlimited potential loss: The risk in the strategy is theoretically unlimited (in the case of call options) since the trader is short 2 naked calls. If the underlying asset’s price moves significantly past the short strike, the losses can be substantial.

As a result of this potential unlimited risk, we are always prepared to manage the position by closing or rolling the short options when the price moves unfavourably and never recommend this for newer traders.

One could see how this strategy would be much more dangerous in a higher IV environment due to the naked short options. However, during extended low IV markets, the probability of a larger move that takes the underlying asset’s price beyond the short strike prior to the options expiry is much lower, and a risk we’re willing to take and manage if necessary.

In our experience, this strategy is best suited to near-term expiries to take advantage of potential market events without knowing how long the low IV conditions will persist.

In what low IV situations do we use a 1x3 ratio spread when trading crypto options?

The most common situations where we find ourselves using the 1x3 ratio spread are:

1. When in a well-established low IV environment
2. Betting on a market move around financial numbers such as earnings or economic events such as FOMC, etc.
3. Ideally, the short strikes can be positioned at or beyond technical support or resistance, recent highs or lows, etc.

Conclusion

In conclusion, the 1x3 ratio spread is a handy strategy in crypto options trading that allows us to make directional bets in a low IV market and often get paid to do so. While risk needs to be managed, the strategy makes money in every scenario unless the underlying asset price moves beyond the short strike price by options expiration.