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.