A Bear Put Ratio Back spread is a bearish strategy and is potentially an alternative to simply buying put options. There are two components to the put ratio backspread:
- Sell one (or two) at-the-money or out-of-the money puts
- Buy two (or three) put options that are further out-of-the money from the money than the put that was sold.
Put Ratio Backspread Expectations
The ratio backspread is called such because there is a ratio of sold options to purchased option usually in the ratio of 1 sold to 2 purchased, or 2 sold to 3 purchased. A trader would use a Bear Put Ratio Backspread in the following hypothetical situation:
- A trader is very bearish on a particular stock trading at $50.
- The trader is either risk-averse, wanting to know before hand their maximum loss or wants greater leverage than simply owning stock.
- The trader expects the stock to move below $45.46 or not move at all or even rise in the next 30 days. However, a move lower to only $47.50 would prove disasterous for the trade.
Given those expectations, the trader selects the $47.50 put option strike price to buy twoputs which are trading for $0.44 each so the total cost will be $88 (2 contracts x $0.44 x 100 shares/contract).
Also, the trader will sell one the at-the money put strike price at $50.00. By selling this call, the trader will receive $134 ($1.34 x 100 shares/contract). The net effect of this transaction is that the trader will receive $33 ($134 received - $88 paid).
Put Ratio Backspreads require Extreme Bearishness
For this trade, a trader must be extremely bearish on the stock. Only being slightly bearish will not work for this trade. One of the strange aspects of a bear put ratio backspread like the one in this example is that the greatest loss occurs in the direction the trader is hoping the trade will move (i.e. downwards).
The greatest loss occurs at the strike price of the purchased put options. The reason for this is that at $47.50, at expiration, the puts the trader purchased expire worthless ($88 loss). Meanwhile, the one put the trader sold has gained value and would be worth $250. The trader sold the put option for $134, so the sold put option has accrued a loss of $116 ($134 - $250). Combined with the loss suffered from the purchased options that expired worthless, the total loss is $204 ($88 + $116). The profit/loss graph on the next page illustrates this.
Once the stock price falls below the strike price of the purchased puts (i.e. point of max loss), then the losses begin to decrease and eventually a profit occurs. This is because at the point of max loss, one put option that was purchased effectively begins to neutralize the option that was sold. One of the purchased options cancels out the movement of the onesold option. From there, the one remaining purchased option is free to begin to make a profit, just like if the trader only purchased a put option. In order to more clearly understand this past paragraph, the concept of delta must be understood.
Possible to make money if stock goes up
Yet another odd aspect of the bear put ratio backspread is that sometimes the trade will make money if the stock moves in the exact opposite direction the trader is expecting (i.e. upward). For instance, if the stock moves nowhere for 30 days and remains at $50.00, then the two puts the trader purchased would expire worthless ($88 loss). However, the one put the trader sold expired worthless also. Remember, the trader sold the option for $134; therefore, the trader actually gained on the transaction $46 ($134 gain - $88 loss).
The profit/loss graph for the bear put ratio backspread is given on the next page.
