Put
Ratio Backspread
Description
The
Put Ratio Backspread is almost the precise opposite of the Call Ratio
Backspread. It enables us to make accelerated profits, provided that the stock
moves sharply downwards. Increasing volatility is very helpful because we’re
net long in puts. The worst thing that can happen is that the stock doesn’t
move at all, and even a sharp move up can be profitable, or at the very least,
preferable to no movement at all.
The
Put Ratio Backspread involves buying and selling different numbers of the same
expiration puts. Typically we buy and sell puts in a ratio of 2:1 or 3:2, so we
are always a net buyer. This gives us the uncapped profit potential. It also
reduces the net cost of doing the deal such that we can even create a net
credit! Furthermore, our risk is capped, though we need to investigate the
strategy further in order to understand it better.
Market
Opinion
Very
bearish.
P/L
When
To Use
Use
this strategy when you are in a bearish environment, believe the stock price
will radically drop, and want capital gains.
Example
XXXX
is trading at $27.98 on May 10, 2011.
Buy
two January 2012 25 strike puts at $2.15.
Sell
one January 2012 30 strike put at $4.20
Benefit
The
benefit of this strategy is that you have reduced your cost of the trade while
capping your risk and benefiting from higher leverage as the stock drops.
Risk
vs. Reward
The
risk is the difference between strikes minus net credit, multiplied by the
number of contracts you are selling. The reward would be unlimited until the
stock drops to zero.
Net
Upside
Unlimited
until the stock drops to zero.
Net
Downside
Difference
in strikes minus net credit received, or plus net debit paid.
Break
Even Point
Break
even up: higher strike minus net credit.
Break
even down: lower strike minus difference in strike prices times the number of
short puts, divided by the number of long puts minus number of short puts, plus
net credit or minus net debit paid.
Effect
Of Volatility
High
volatility.
Effect
Of Time Decay
Negative.
You need time because you are looking for a significant move.
Alternatives
Before Expiration
If
the stock goes above the stop loss, unravel the position.
Close
out the entire position at least one month in advance of expiration to stem
losses or capture profit.
Alternatives
After Expiration
Close
out entire position by buying back the puts sold and selling the puts bought.