The Put Ratio Backspread Explained

05/28/2013 8:00 am EST

Focus: OPTIONS

Michael Thomsett

Founder, Thomsett Publishing Website

Most traders think of the put ratio backspread as a bearish strategy, but Michael Thomsett of ThomsettOptions.com, clarifies that it is really a volatility play.

Is the backspread always a bear strategy? Most traders think of the put ratio backspread in this way. Why? Because it involves puts. But in fact, it is not a bear strategy, but a volatility strategy. That means it's designed to turn profitable due to fast point movement in the underlying.

The put ratio backspread is designed to create a net close to zero, meaning very small credit adequate to cover trading costs and perhaps a little more. The potential loss is limited, but profit potential depends on the direction of price movement. Time decay plays a major role, creating profitable status in the short side while waiting out the price movement on either side.

The put ratio backspread has two elements. First is that it combines short and long puts. Second, the ratio refers to the disparity in the number of long and short positions. Typically, the strategy combines ATM or ITM long puts with a smaller number of ITM short puts. While the ITM puts are at risk of exercise, there are two offsetting advantages. First, the exercised puts can be covered with your long puts (so the loss is limited to the distance between the strikes). Second, both time decay and changes in the implied volatility will work to reduce premium value, so you can close one or more of the shorts at a profit, often very soon after they were opened.

For example, if you buy three long ATM and sell two ITM puts, you set up a 3:2 put ratio backspread. For example, share price is $39.17. The APR 38 puts are at 0.82 and the APR 40 puts at 1.75. You set up a 3:2 put ratio backspread with the following:

Buy three APR 38 puts @ 38 = -$114
Sell two APR 40 puts @ 1.75 =  $350
Net credit                             $236

The net credit is adequate to cover the net loss in the case of one exercise. However, volatility may create fast changes in IV, so that the short positions can be closed profitably. If the stock price declines, these can also be rolled forward. The net exposure is only one contract (3:2 ratio), but the net premium is a 2.36 credit.

You will discover that stocks with one-point strike increments provide the best flexibility. When compared to a 2.5-point or 5-point space, you will see that the exercise exposure is more advantageous in the smaller strike situations.

By Michael Thomsett of ThomsettOptions.com

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