The put ratio backspread inverts the paradigm of the long ratio put spread. Rather than limited reward and high risk, the trader is positioned to enjoy limited risk and a reward that's potentially much greater. The spread is best reserved for experienced speculators who are expecting a drastic downside move from the underlying stock, as a modest decline won't be sufficient to generate profits on this gutsy trade.
To find out how the put ratio backspread works, let's look at an example.
Downtrending Stock XYZ has been hovering around the $55 level for several weeks now, and you expect the shares to embark on another sudden drop lower during the near term. To bet on a big decline, you sell to open one in-the-money 57.50-strike put at the bid price of 3.20, and simultaneously buy to open two out-of-the-money 52.50-strike puts at the ask price of 0.80.
Subtracting the cost of your two purchased puts (0.80 x 2 = 1.60) from the premium you collected on the sale of your sold put (3.20), you've entered the spread at a net credit of 1.60 (3.20 - 1.60). Multiplied by 100 shares per contract, that's $160 in your pocket to begin.
There are a couple of paths to profit on your put ratio backspread. Even if the stock completely defies your expectations and rallies above the sold put strike by expiration, you can still retain the initial net credit of 1.60, or $160, as your profit on the play.
Should the shares decline, you'll begin to profit once XYZ falls below the lower breakeven rail, which is calculated by taking the difference between the two put strikes, minus the net credit, and subtracting the entire amount from the purchased put strike. In this case, that's 52.50 - [(57.50 - 52.50) - 1.60] = 49.10. So, on any move by XYZ below $49.10 per share, your profits will begin to accrue.
The maximum possible gain will occur on a move down to zero, and is equivalent to the lower breakeven rail less stock price at expiration -- so with XYZ at $0, you could gain up to 49.10, or $4,910.
The put ratio backspread will incur losses on a modest move lower. The upper breakeven rail is equivalent to the sold put strike less net credit, or 57.50 - 1.60 = 55.90. At this point, you will have lost all of your initial net credit, and you won't begin to see profits until the aforementioned lower breakeven rail is broken to the downside.
The worst-case scenario would be for XYZ to close right at the purchased put strike of 52.50, which would return the maximum loss -- or the difference between the two strikes, less the net credit received. In this example, the most you can lose is 3.40, or -- after accounting for 100 shares per contract -- $340.
Since a put ratio backspread requires you to purchase twice as many puts as you've sold, it's typically preferable for implied volatility to rise once you've entered the trade. While the value of your sold put will increase, so will the premiums on your two long puts.
The put ratio backspread can also be constructed using different ratios, such as 3:2 or 5:3.
Depending upon your strike selection and the ratio of puts used, the put ratio backspread may also be initiated for a net debit. If so, the maximum loss on a move down to the purchased put strike is equivalent to the difference between the two strikes, plus the net debit to enter the position. Profits will begin to accrue on a move below the sole breakeven point, which is equivalent to the purchased put strike less the maximum potential loss.
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