A put ratio backspread is a bearish options strategy: you sell one higher-strike put and buy a larger number of lower-strike puts (for example 1:2) with the same expiration, often for a small net credit. It makes the most money if the stock falls sharply below the lower breakeven, earns a small profit (the credit) if the stock rises, and has its maximum loss if the stock closes exactly at the long strike. In the example below, that maximum loss is $400 per spread. Options involve risk, and the Put Ratio Backspread is one way to shape it.
What is the put ratio backspread?Put ratio backspread involves buying more puts at a lower strike(OTM) and selling fewer puts with a higher strike(ITM). Long and short puts must have the same underlying asset and expiration date. It is called as put ratio backspread because investors built the ratio of long and short puts, say 2:1, 3:1, 3:2, etc. This strategy offers large profit potential on a sharp decline (limited only by the stock falling to zero) with limited potential risk. Investors can build this strategy on zero cost, net credit, or sometimes on the net debit depending upon the variation of long and short puts. When to execute?
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When an investor has a bearish view on the stock and expects it will go down considerably.
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Put ratio backspread works best on the highly volatile stock, as it provides an opportunity to earn a limited profit if the stock moves in the upward direction and a large profit on a sharp downside move of the underlying asset.
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Put ratio backspread is applied when the underlying asset is greatly influencing by the events like quarterly reports of the company, election results, etc.
Example of Put Ratio Backspread
Suppose the stock of XYZ is currently at $47, an investor has a bearish view. He sells 1 XYZ 50.00 put at $4 and buys 2 XYZ 45.00 puts at $1.50(1Lot="100"shares).
Net Cash Flow= Premium received – Premium Paid i.e $1 (Net Credit).
** Profit and Loss position at different spot prices on the expiration date-** ** It is visible from the above table**
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We will suffer a maximum loss of $400 ($4*100) if the stock closes at the long put strike of $45 as both of our long puts will become worthless.
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There are two break-even points at $41(downside) and $49(upside).
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If the spot price remains higher than $49(upside break-even) we will earn a limited profit of $100(only in case of net credit spread).
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The loss will incur if the stock remains in the range of $42-$48.
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Profits will increase as long as the stock moves down beyond the $41 (downside break-even).
Key Metrics 1. Maximum Loss
Maximum Loss = (Strike Difference – Net Credit)*100
= $(5-1)*100
= $400
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**Upside Breakeven **Upside Breakeven = Short Strike – (Net Credit / No. of Short Puts)
= $50 – ($1/1)
= $49 3.** Downside Breakeven**
Downside Breakeven = Long Strike – (No.Short Puts * Strike Difference) + Net Credit
= $45 – (1*5) + $1
= $41
Payoff Graph Of Put Ratio Backspread (Net Credit Spread) ** From the above graph, it can be concluded:**1. Profits grow as the stock falls below the downside breakeven, up to the point where the stock reaches zero.
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Maximum loss occurs at the long strike $45 as both the option will become worthless.
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Limited profits can be earned if the stock moves upward.
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There are two breakeven points in this strategy.Payoff graph for the different cost strategies
1.** Net Credit Spread**When the premium received on the short put is greater than the premium paid on long puts, a net credit spread is being created. With net credit spread, limited profit can be earned if the underlying asset moves upwards beyond the upside breakeven.
For example:
2.Even Money Spread
When the difference in the premium earned on writing puts and buying puts is zero, even money spread is being created. It is also called as “Zero Cost Strategy”. It doesn’t provide an opportunity to earn a limited profit if the stock moves upward.
For example:
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Debit Money Spread
When the premium received on the short put is lesser than the premium paid on long puts, the net debit spread is being created. It will increase the cost of transactions and the potential risk of the stock.
For example:
Advantages of Put Ratio Backspread1. To lower down the strategy cost.
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To earn higher profits in case of a sharp price decline.
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To generate profit even if the stock doesn’t move as per expectation(In case of net credit).
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To limit the loss in the worst-case scenario. Limitations of Put Ratio Backspread1. Range bound movements or slow decline can result in a loss.
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Downside break-even is lower when compared to the simple put purchase.
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This strategy is not suitable for the less volatile stocks. ConclusionPut Ratio Backspread helps to limit the risk of an underlying asset and provides an opportunity to earn a profit on either side movement of the stock. But it does not eliminate the risk. It should be applied to the more volatile stocks. An investor must be sure that the stock moves down considerably and choose an appropriately long and short strike. The risk varies with the ratio of long and short puts and the difference in their strike price. For comparison, read the Put Ratio Spread setup and risk guide, which covers a different arrangement of long and short puts.
DisclaimerNone of the content published on marketxls.com constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. The author is not offering any professional advice of any kind. The reader should consult a professional financial advisor to determine their suitability for any strategies discussed herein. The article is written for helping users collect the required information from various sources deemed to be an authority in their content. The trademarks if any are the property of their owners and no representations are made. ** Reference**
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