Put Backspread Options Strategy
Put backspreads, also known as put ratio backspreads, are an advanced options trading strategy used by experienced traders and investors to profit from market volatility. This strategy involves selling a certain number of put options at a specific strike price and simultaneously buying a greater number of put options at a lower strike price. The aim is to create a spread that benefits from a significant downward price movement in the underlying asset, while also limiting potential losses in case the market moves in the opposite direction.
In this article, we will take a closer look at put backspreads, how they work, and the advantages and disadvantages to consider before using them in your trading strategy.
What Is a Put Backspread?
A put backspread is a bearish options trading strategy that involves selling a higher strike put option while simultaneously buying a greater number of lower strike put options. It’s essentially a bull put spread plus an additional put purchased at the same strike price as the long put. All options in the spread have the same expiration date.
The sale and purchase of the put options may result in a net credit or debit, but usually, it results in a credit. The strategy offers unlimited profit potential if the underlying asset’s price decreases significantly, specifically if it moves below the long put strike price. However, the maximum loss is limited and is calculated as the difference between the strike prices minus the credit.
Put Backspread Example
Let’s say the stock ABC is currently trading at $50, and you believe it has the potential to decrease in price, you could initiate a put backspread strategy by selling one put option with a higher strike price and purchasing two put options with a lower strike price.
Here’s an example of how the put backspread strategy could be implemented:
- Sell 1 ABC $60 put option for $3 premium
- Buy 2 ABC $40 put options for a total premium of $2.50 ($1.25 per option)
Overall, you would receive a net credit of $0.50 ($3 premium received from selling the put option minus the $2.50 premium paid for the two purchased put options).
Here are a few scenarios that could occur:
- The stock price falls below the long put strike price ($40), resulting in both long puts being in the money and you would profit from the long puts, plus the net credit, minus the cost of closing the short put.
- The stock price is $40 at expiration, resulting in the long puts expiring worthless and you would profit from the net credit minus the cost of closing the short put.
- The stock price rises to or above the short put strike price ($60), resulting in all the options expiring worthless and you profit from the net credit.
How to Trade a Put Backspread
Here are the general steps for trading a put backspread:
- Identify a bearish market scenario: Put backspreads are most effective in bearish market scenarios where the investor expects the price of the underlying asset to decrease significantly. Analyze market trends and technical indicators to identify potential opportunities for bearish trades.
- Select strike prices: Select a higher strike price for the put options that you plan to sell and a lower strike price for the put options that you plan to buy.
- Determine the number of contracts: Determine the number of put options to sell and buy based on your trading objectives and risk tolerance.
- Place the trade: Place the trade by simultaneously selling the higher strike put options and buying the lower strike put options. This will result in a net debit or credit, depending on the premiums of the put options.
- Monitor and manage the trade: Monitor the trade regularly and adjust the position as needed based on changing market conditions. This may involve rolling the options to different strike prices or adjusting the number of contracts to manage risk and maximize profit potential.
Trading a put backspread requires careful consideration of the investor’s risk tolerance, trading goals, and market conditions.
How to Adjust a Put Backspread
Here are a few ways to adjust a put backspread:
- Roll the spread: If the underlying asset price moves against the position, you may consider rolling the spread to a later expiration date or to a different strike price. This can help to manage risk and extend the trade’s duration.
- Add more contracts: If the underlying asset price moves in the expected direction, you may consider adding more contracts to the spread to increase potential profit. This can also help to lock in profits and manage risk.
- Close the spread: If the underlying asset price moves too far against the position, you may consider closing the spread to limit losses. This is especially important if the underlying asset price moves above the higher strike price of the spread.
- Adjust the ratio: You can adjust the ratio of the put options that you sell and buy to manage risk and maximize profit potential. For example, you can increase the number of put options that you buy relative to the number that you sell to increase profit potential, or decrease the number that you buy relative to the number that you sell to decrease risk.
As with any trading strategy, it is important to carefully consider the potential risks and benefits of any adjustments before making them, and to monitor the position regularly to ensure it aligns with your trading goals and risk tolerance.
Pros and Cons of Put Backspreads
Here are some potential pros and cons of using a put backspread options trading strategy:
- Unlimited profit potential: With a put backspread, there is no limit to the amount of profit that can be made if the underlying asset price falls significantly, making it an attractive strategy for bearish traders.
- Limited risk: The maximum potential loss for a put backspread is limited to the difference between the strike prices minus the net credit recieved, which provides a certain degree of protection against potential losses.
- Flexibility: Put backspreads can be customized to fit a trader’s specific goals and risk tolerance. This means that traders can adjust the ratio of options sold to options bought or select different strike prices to suit their individual preferences.
- Complex strategy: Put backspreads are a complex trading strategy that can be challenging to understand for novice traders. A good understanding of options trading and market dynamics is essential to successfully implementing this strategy.
- Requires careful management: As with any trading strategy, put backspreads require careful monitoring and management to ensure that the spread remains profitable. If the underlying asset price moves in the opposite direction, the spread may need to be adjusted or closed out to limit potential losses.
- Potential for early assignment: When selling put options as part of a put backspread, there is a risk of early assignment if the price of the underlying asset falls below the higher strike price. This can result in the investor being forced to buy the underlying asset at a higher price than the current market value, potentially resulting in losses.
As with any trading strategy, investors should carefully consider the pros and cons and their individual risk tolerance before using a put backspread.
The Bottom Line
In conclusion, put backspreads can be an effective strategy for experienced options traders seeking to profit from significant downward price movements in the underlying asset while managing potential losses. By selling a certain number of put options at a higher strike price and simultaneously buying a greater number of put options at a lower strike price, traders can create a spread with unlimited profit potential.
However, it’s important to note that put backspreads are a complex strategy that requires a good understanding of options trading and market dynamics. Traders and investors should carefully weigh the risks and rewards, including the maximum profit and loss potential, before incorporating this strategy into their portfolio. With proper knowledge and risk management techniques, put backspreads can be a valuable addition to a trader’s options toolkit.