Put Backspread Explained

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Back Spread w/Puts

AKA Ratio Volatility Spread; Pay Later Put

NOTE: This graph assumes the strategy was established for a net credit.

The Strategy

This is an interesting and unusual strategy. Essentially, you’re selling an at-the-money short put spread in order to help pay for the extra out-of-the-money long put at strike A.

Ideally, you want to establish this strategy for a small net credit whenever possible. That way, if you’re dead wrong and the stock makes a bullish move, you can still make a small profit. However, it may be necessary to establish it for a small net debit, depending on market conditions, days to expiration and the distance between strikes B and A.

Ideally, it would be nice to run this strategy using longer-term options to give the stock more time to move. However, the marketplace isn’t stupid. It knows that to be the case. So the further you go out in time, the more likely it is that you will have to establish the strategy for a debit.

In addition, the further the strikes are apart, the easier it will be to establish the strategy for a credit. But as always, there’s a tradeoff. Increasing the distance between strike prices also increases your risk, because the stock will have to make a bigger move to the downside to avoid a loss.

Notice that the Profit + Loss graph at expiration looks quite ugly. If the stock only makes a small move to the downside by expiration, you will suffer your maximum loss. However, this is only the risk profile at expiration.

After the strategy is established, if the stock moves to strike A in the short term, this trade may actually be profitable if implied volatility increases. But if it hangs around there too long, time decay will start to hurt the position. You generally need the stock to continue making a bearish move well past strike A prior to expiration in order for this trade to be profitable.

Options Guy’s Tips

If you own a volatile stock, this is a potential way to protect your investment against a large downturn with a smaller cash outlay than it would take to purchase a put outright for protection.

This is a trade you might want to consider just prior to a major news event if you expect the outcome to be negative. Examples include pending FDA rejection of a “miracle drug” on a pharmaceutical stock or a bad outcome from a major legal case. A real-life example of when this strategy might have made sense was in the banking sector during the sub-prime mortgage crisis of 2008.

The Setup

  • Sell a put, strike price B
  • Buy two puts, strike price A
  • Generally, the stock will be at or around strike price B

NOTE: Both options have the same expiration month.

Put Backspread Explained – Back Spread Options Strategy

What is Put Backspread?

The Put Backspread is reverse of Put Ratio Spread. It is a bearish strategy that involves selling options at higher strikes and buying higher number of options at lower strikes of the same underlying asset. It is unlimited profit and limited risk strategy.

When to initiate the Put Backspread

The Put Backspread is used when an option trader believes that the underlying asset will fall significantly in the near term.

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How to construct the Put Backspread?

Sell 1 ITM/ATM Put

The Put Backspread is implemented by selling one In-the – Money (ITM) or At-the-Money (ATM) put option and buying two Out-the-Money (OTM) put options simultaneously of the same underlying asset with the same expiry. Strike price can be customized as per the convenience of the trader.

Strategy

Market Outlook

Significant downside movement

Upper Breakeven

Strike price of short put -/+ premium paid/ premium received

Lower Breakeven

Long put strike – Difference between Long and Short strikes (-/+) premium received or paid

Risk

Reward

Unlimited (when Underlying price

Margin required

Let’s try to understand with an Example:

NIFTY Current market Price Rs

Sell ATM Put (Strike Price) Rs

Premium received (Rs)

Buy OTM Put (Strike Price) Rs

Premium paid (per lot) Rs

Net Premium Paid/Received Rs

Suppose Nifty is trading at Rs 9300 . If Mr. A believes that price will fall significantly below 9200 on or before expiry , then he can initiate Put Backspread by selling one lot of 9300 p ut strike price at Rs 1 40 and simultaneously buying two lot of 9200 put strike price at Rs 70. The net premium paid/received to initiate this trade is zero. Maximum profit from the above example would be unlimited if underlying asset breaks lower breakeven point. However, maximum loss would be limited to Rs 7,500 (100*75) and it will only occur when Nifty expires at 9200.

For the ease of understanding, we did not take in to account commission charges. Following is the payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry NIFTY closes at

Net Payoff from 9300 Put Sold (Rs)

Net Payoff from 9200 Put Bought (Rs) (2Lots)

Net Payoff (Rs)

9200

40

-140

-100

The Payoff Graph:

Impact of Options Greeks:

Delta: If the net premium is paid, then the Delta would be negative, which means any upside movement will result into premium loss, whereas a big downside movement would result in to unlimited profit. On the other hand, If the net premium is received from the Put Backspread, then the Delta would be positive, which means any upside movement above higher breakeven will result into profit up to premium received.

Vega: The Put Backspread has a positive Vega, which means an increase in implied volatility will have a positive impact.

Theta: With the passage of time, Theta will have a negative impact on the strategy because option premium will erode as the expiration dates draws nearer.

Gamma: The Put Backspread has a long Gamma position, which means any major downside movement will benefit this strategy.

How to manage Risk?

The Put Backspread is exposed to limited risk; hence one can carry overnight position.

Analysis of Put Backspread:

The Put Backspread is best to use when investor is extremely bearish because investor will make maximum profit only when stock price expires at below lower (bought) strike.

Bear Put Ratio Backspread – A Good Alternative To Buying Put Options

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Last Updated on February 22, 2020

A Bear Put Ratio Backspread is a bearish strategy and is potentially an alternative to simply buying put options. There are two components to the put ratio backspread:

  • Sell one (or two) at-the-money or out-of-the money puts
  • Buy two (or three) put options that are further out-of-the money from the money than the put that was sold.

Put Ratio Backspread Expectations

The ratio backspread is called such because there is a ratio of sold options to purchased option usually in the ratio of 1 sold to 2 purchased, or 2 sold to 3 purchased. A trader would use a Bear Put Ratio Backspread in the following hypothetical situation:

  1. A trader is very bearish on a particular stock trading at $50.
  2. The trader is either risk-averse, wanting to know before hand their maximum loss or wants greater leverage than simply owning stock.
  3. The trader expects the stock to move below $45.46 or not move at all or even rise in the next 30 days. However, a move lower to only $47.50 would prove disasterous for the trade.

Given those expectations, the trader selects the $47.50 put option strike price to buy two puts which are trading for $0.44 each so the total cost will be $88 (2 contracts x $0.44 x 100 shares/contract).

Also, the trader will sell one the at-the money put strike price at $50.00. By selling this call, the trader will receive $134 ($1.34 x 100 shares/contract). The net effect of this transaction is that the trader will receive $33 ($134 received – $88 paid).

Put Ratio Backspreads require Extreme Bearishness

For this trade, a trader must be extremely bearish on the stock. Only being slightly bearish will not work for this trade. One of the strange aspects of a bear put ratio backspread like the one in this example is that the greatest loss occurs in the direction the trader is hoping the trade will move (i.e. downwards).

The greatest loss occurs at the strike price of the purchased put options. The reason for this is that at $47.50, at expiration, the puts the trader purchased expire worthless ($88 loss). Meanwhile, the one put the trader sold has gained value and would be worth $250. The trader sold the put option for $134, so the sold put option has accrued a loss of $116 ($134 – $250). Combined with the loss suffered from the purchased options that expired worthless, the total loss is $204 ($88 + $116). The profit/loss graph on the next page illustrates this.

Once the stock price falls below the strike price of the purchased puts (i.e. point of max loss), then the losses begin to decrease and eventually a profit occurs. This is because at the point of max loss, one put option that was purchased effectively begins to neutralize the option that was sold. One of the purchased options cancels out the movement of the one sold option. From there, the one remaining purchased option is free to begin to make a profit, just like if the trader only purchased a put option. In order to more clearly understand this past paragraph, the concept of delta must be understood.

Possible to make money if stock goes up

Yet another odd aspect of the bear put ratio backspread is that sometimes the trade will make money if the stock moves in the exact opposite direction the trader is expecting (i.e. upward). For instance, if the stock moves nowhere for 30 days and remains at $50.00, then the two puts the trader purchased would expire worthless ($88 loss). However, the one put the trader sold expired worthless also. Remember, the trader sold the option for $134; therefore, the trader actually gained on the transaction $46 ($134 gain – $88 loss).

The profit/loss graph for the bear put ratio backspread is given on the next page.

Put Ratio Backspread Profit & Loss Graph

The following is the profit/loss graph at expiration for the Bear Put Ratio Backspread in the example given on the previous page.

Break-even

The breakeven point for the bear call ratio backspread is given next:

  • Breakeven Stock Price1 = Sold Call Option Strike Price – Net Premium Sold (Cost of Options Sold – Cost of Options Purchased). Note: This breakeven might not exist with every bear put ratio backspread a trader trades (i.e. if there is net premium purchased rather than sold).
  • Breakeven Stock Price2 = Sold Call Option Strike Price – 2 x Distance between strike prices of the call sold and the calls purchased + Net Premium Sold or – Net Premium Purchased.

To illustrate, the trader sold the $50.00 strike price put option for $1.34, and also bought two options at the $47.50 strike price for $0.44 each, for a net premium sold of $0.46 ($1.34 – $0.88). The strike price sold was the $50.00. Therefore, $50.00 – $0.46 = $49.54. The trader will breakeven, excluding commissions/slippage, if the stock is above $49.54 by expiration.

For the second breakeven, the distance between the two strike prices is $2.50 ($50.00 – $47.50). Consequently, 2 times $2.50 is $5.00. The net premium sold was $0.46. The sold put option strike price is $50.00. Summing everything together, $50.00 – $5.00 + $0.46 = $45.46. As such, the two breakeven points are $45.46 and $49.54.

Profit

The profit for a bear put ratio backspread is as follows:

  • Bear Put Ratio Backspread Profit = Breakeven price – Stock price at expiration

To continue the example, if the stock price at expiration is $44.00, then the profit would be $146 [($45.46 – $44.00) x 100 shares/contract].

To the upside, the max profit is $46 anywhere above the strike price of the option sold. This profit area to the upside might not exist for all bear put ratio backspreads.

Partial Loss

A partial loss occurs between the put strike price sold and the put strike price purchased. A partial loss also occurs between the point of max loss and the downside breakeven. The calculation is given next:

  • Bear Put Ratio Backspread Partial Loss1 = (Strike Price of Option Sold – Stock Price at Expiration) – Net Premium Sold or + Net Premium Purchased

For example, if the stock price was $48.00 at expiration and the strike price of the option sold is $50.00 and net premium sold was $0.46, then [($48.00 – $50.00) + $0.46] x 100 shares/contract = $154 loss.

  • Bear Put Ratio Backspread Partial Loss2 = (Downside Breakeven Stock Price – Stock Price at Expiration)

To illustrate, if the stock price at expiration was $47.00 and the downside breakeven stock price was $45.46, then [($45.46 – $47.00) x 100 shares/contract] = $154 loss.

Max Loss

As stated previously, the max loss occurs at the strike price of the puts purchased. The formula is as follows:

  • Bear Put Ratio Backspread Max Loss= (Strike price of put sold – Strike price of puts purchased) + Net Premium Purchased or – Net Premium Sold.

As an example, the strike price of the puts purchased is $47.50, the strike price of the put sold is $50.00, and the net premium sold is $0.46: ($50.00 – $47.50) – $0.46 = $2.04 x 100 shares/contract = $204.

Bear Put Ratio Backspread vs Put Option

Both the profit/loss graph at expiration for the Bear Put Ratio Backspread and a Put are given below.

Break-even

The put is superior than the bear put ratio backspread when it comes to the better downside breakeven.

  • Bear Put Ratio Backspread = $45.46
  • Put = $47.06

Profit

The profit for a bear put ratio backspread is less than a put. The profit at a stock price of $45 is given below :

  • Bear Put Ratio Backspread = $46
  • Put = $206

At a stock price of $50 (i.e. stock did not move in 30 days) the bull call ratio backspread actually makes money, whereas the put loses money:

  • Bear Put Ratio Backspread = $46
  • Put = -$44

However, at a price of $47.50, the bear put ratio backspread is very inferior to the put.

  • Bear Put Ratio Backspread = -$204
  • Put = -$44

Like all option strategies, the trader’s exact expectations have to be considered when deciding the best strategy to use:

  • Direction of stock move
  • Magnitude (size) of stock move
  • Time frame of stock move
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