Put Ratio Backspread

When to Apply the Put Ratio Backspread

As with other volatile strategies, you would use the put ratio backspread when you are expecting a security to move substantially in price but aren't sure in which direction. With this specific strategy, you would use it when you think the price is more likely to go down but also want to profit if it goes up.

It will profit either way, providing the price movement is large enough, but the profits will be higher if the price goes down than if it goes up. It will result in a loss if the price of the underlying security does not move, or only moves a little. Therefore, you should only use this strategy if you are confident that there will be a sizable price movement.

How the Put Ratio Backspread is Applied

The put ratio backspread has two legs, one which requires buying puts and one which requires writing puts. As the name suggests, this is a ratio spread: so there's a different amount of options in each of the two legs. In this case, you should buy twice as many puts as you write.

The ones that you buy need to be at the money and the ones that you write should be in the money. How much in the money they should be is ultimately down to your own choice, but you must ensure that you create a credit spread. This means that the total amount received for writing the options needs to be higher than the total amount spent on buying options. You also need to ensure that both legs use the same expiration date.

For clarification on how the put ratio backspread is applied, please see the example below.

Example of a Put Ratio Backspread

To keep the below example as clear as possible, we have used rounded prices rather than exact market data. We have also ignored commission costs.

• Company X stock is trading at $50, and you believe the price will probably drop substantially but believe there is also chance it may go up substantially.
• Puts with a strike of $50 are trading at $2. You buy 2 contracts (each containing 100 of these options) for a total cost of $400. This is Leg A.
• Put with a strike of $54 are trading at $5. You write 1 contract of these, and receive a credit of $500. This is Leg B.
• You have established the put ratio backspread for a net credit of $100.
• If the price of Company X stock is still $50 at the time of expiration, then the options bought in Leg A will expire worthless and the ones written in Leg B will be worth around $4 each ($400 in total). You will have a liability of $400, partially offset by initial net credit of $100. Your total loss will be $300.
• If the price of Company X stock moves up to $52 by expiration, then the options purchased in Leg A will be worthless, but the ones written in Leg B will be worth around $2 each ($200 total).You'll have a liability of $200 and after taking into account your initial net credit of $100, you will have lost $100.
• If the price of Company X stock is at $55 by expiration, then the options bought in Leg A will be worthless, as will the ones written in Leg B. With no further returns and no further liabilities, you will profit the initial $100 credit.
• If the price of Company X stock drops to $48 by expiration, then the put options bought in Leg A will be valued at around $2 ($400 total) and the put options written in Leg B will be valued at around $6 each ($600 total). You will have a total liability of $600 but this will be partially offset by the $400 value of the options you own and the $100 initial net credit. Your total loss will be $100.
• If the price of Company X stock drops to $45 by expiration, then the options you bought in Leg A will be worth around $5 each ($1,000 total) and the ones you wrote in Leg B will be worth around $9 each ($900 total). With a return of $1,000 plus your initial $100 net credit, minus the $900 liability, you will have made a $200 profit.

Calculating Profit, Loss & Break-Even Points

As long as the price of the underlying security makes a big enough move, then the spread will return an overall profit, although the profits will be higher if the price movement is downward. It will result in a loss if the price doesn't move at all or only moves a little.

Below we have shown the break-even calculations of the spread, how it can return a profit and how it can return a loss.

• A profit is made if “Price of Underlying Security > Upper Break-Even Point” or “Price of Underlying Security < Lower Break-Even Point”
• Upper Break-Even Point = “Strike of Leg B – (Total Net Credit / Number of Options Written in Leg B)”
• Lower Break-Even Point = “Strike of Leg A – (Strike of Leg B - Strike of Leg A) + (Total Net Credit / Number of Options Written in Leg B)”
• Maximum profit is unlimited if “Price of Underlying Security < Lower Break-Even point”. The lower the price of the underlying security drops the more profit is made.
• Maximum profit is limited to Total Net Credit if “Price of Underlying Security < Upper Break Even Point”.
• Maximum loss occurs when “Price of Underlying Security = Strike of Leg A”
• Maximum loss is limited to “((Strike of Leg B – Strike of Leg A) x Number of Options written in Leg B) – Total Net Credit”

Summary

Despite the complexities of the put ratio backspread compared to some alternative strategies, it's definitely worth considering if the situation is right. If you are confident of a big price movement in either direction and reasonably sure that a drop is more likely, then it's clearly a good strategy to use.

You’ll make a profit providing the big movement does happen, and the profits can be quite substantial if it does indeed move downwards. If your forecast turns out to be wrong, at least the potential losses are limited. Although this strategy does have advantages, we would recommend that beginner traders stick to some of the simpler strategies while starting out.