THE OPTIONS COURSE- PUT RATIO BACKSPREADS

THE OPTIONS COURSE


PUT RATIO BACKSPREADS

The implementation of a put ratio backspread is a great way to play a bear market. A put ratio backspread is a delta neutral (nondirectional risk trade), which allows us to profit substantially from strong downward movement; however, we can also hedge and protect ourselves from upward movement. Thus, if we are incorrect and the stock goes against us, we are in a position where we won’t lose anything, or we may even realize a small profit, depending on how we enter into the trade. I like to use a put ratio backspread when I can identify a stock with a bearish bias and expect the stock to make a significant move. 

If we are correct and the stock makes a strong move to the downside, we’ll be in a position with limited profit potential (the stock can only fall to zero). If we are wrong and the stock moves against us, we can let the options expire worthless, not have to pay commissions to exit, and not lose any money or even make a little if the trade is placed with a net credit. Placing put ratio backspreads on strong, downtrending stocks will further increase your chances of success. As compared with buying stock, they can offer the same unlimited reward potential but also provide you with limited downside risk. 

Compared with just buying calls, they can offer the same unlimited reward potential with a lower breakeven and less cost. Also, this trade helps to counter some of the impact from volatility in the markets, which allows us to place the trade after news has already come out on a particular stock. A put ratio backspread strategy is created by selling a certain number of higher strike puts and simultaneously buying multiples of a lower strike put. This position is created in a ratio such that you sell fewer calls than you buy in a ratio of .67 or less. For instance, a 1 × 2 consists of one short put and two long puts. 

Similarly, you can create a 2 × 3, 3 × 5, or any combination trade with a ratio less than .67. Put ratio backspreads are best placed in markets with a forward volatility skew. In these markets, the higher strike options (the ones you want to sell) have higher implied volatility and can be overpriced. The lower strike options (the ones you want to buy) enjoy lower implied volatility and are often underpriced. By trading the forward volatility skew, you can capture the implied volatility differential between the short and long options. We want to make sure we give ourselves enough time to be right in this trade. 

The more time we can buy the better. With diligent research we can pinpoint good put ratio backspread trades with longer time frames and many times can even use LEAPS. Also, if we can’t get in at even or for a small credit, then we shouldn’t take the trade. Although this trade can be entered for a small credit, there is still a window of risk. The maximum risk occurs when the stock is at the long strike on the expiration date. The broker will require and hold the risk amount as collateral in your account through the duration of the trade as protection from the worst-case scenario at expiration.

You can use the put ratio backspread to protect any long-term bullish positions and even sell out-of-the-money calls to create an appreciating collar position—a very nimble strategy indeed. Taking into account the put ratio backspread advantages, which are potentially large profits on the downside, you can control the risk by how long you stay in the trade. And having a much lower risk than a long put directional trade, along with the flexibility of using it to create a collar, makes this a strategy worth evaluating when looking for bearish and protective strategies.

To reduce confusion, let’s use the same numbers as the XYZ call ration backspread example to demonstrate a put ratio backspread. Using this strategy, we’ll sell a higher strike put and buy a greater number of lower strike puts. The strikes are the same as before: 40, 45, 50, 55, and 60. The 60 put is the highest strike and comes with the highest intrinsic value and 40 is the lowest. Using this scenario, I could place a wide variety of put ratio backspreads. To further complicate the situation, I could do different ratios on each combination. For this example, I’m going to sell the 60 put and buy a greater number of 55 puts. 

If the market crashes, I’ll lose money to the 55 point; but below 55 I’ll be making more on the 55 puts than I lose on the 60 puts because I have more of the 55 puts.This actually happened to me once in the S&P 500 futures market. If you think the S&P 500 futures market is moving into lofty levels and you don’t want to gamble a lot, you could do a put ratio backspread. I was lucky. The market moved down so fast that month that I made a lot of money. Similarly, if you had placed a put ratio backspread the day the market crashed back in 1987, you wouldn’t need to read this book. You’d be in Aruba, the Bahamas, or somewhere equally relaxing. You’d be laughing all the way to the bank.

Put Ratio Backspread Mechanics

Let’s take a look at the mechanics of a put ratio backspread. A put ratio backspread is composed of the sale of a higher strike put and the purchase of a greater number of lower strike puts. This strategy is best implemented at periods of low volatility in a highly volatile market when you anticipate increasing market activity to the downside (bearish). In placing these kinds of trades, it is essential to create the most effective ratio in markets with increasing volatility, liquidity, and flexibility. Let’s create a new put ratio backspread trade using XYZ at $50 a share during the month of February and look at the January LEAPS two years out. 

Strike prices on the LEAPS are available at 5-point increments. For example, with XYZ trading at $50, the available strikes are 40, 45, 50, 55, and so on. Any put options with strikes above 50 are in-the-money; put options with strikes below 50 are out-of-the-money. Let’s create a put ratio backspread by selling two January 2005 50 puts at $8 and buying five January 2005 40 puts at $3. The short puts generate a credit of $1,600: (2 × $8) × 100 = $1,600. The long puts cost only $300 each or a $1,500 debit. If we divide $1,600 by $300 a contract, we can afford to purchase five long put options and still have a net credit of $100. 

This generates a ratio of 2-to-5, which satisfies the rule of creating ratios less than .67. To calculate the risk, multiply the number of short contracts (2) by the difference in strike prices (10), by the multiplier (100), plus any debit paid (0) or minus any credit received ($100). This gives us a maximum risk of $1,900: [(2 × 10) × 100] – 100 = $1,900). As you can see, we have created a trade with limited reward (the stock can only fall to zero) and a maximum risk of $1,900. Once again, the maximum risk will be realized only if the underlying stock at the time of expiration is equal to the long strike price. 

The upside breakeven is the higher strike put option minus the net credit divided by the number of short puts. In this case, the upside breakeven is 49: [50 – (1 ÷ 2) = 49.50]. If the stock closes above $50 a share, the options expire worthless, but you can keep the credit. The downside breakeven is calculated using the following equation: Lower strike minus the number of short contracts times the difference in strike prices divided by the number of long options minus the number of short options plus the net credit (or subtract the net debit). In this trade, the downside breakeven is 34.33: 40 – [(50 – 40) × 2] ÷ (5 – 2) + 1 = 34.33. 

This trade makes money as long as the price of the underlying closes below the downside breakeven. If the trade had been entered with a net debit, the upside breakeven would not exist. This put ratio backspread works because the further the market gets away from the strike where you originally purchased the options, the more money the trade will make. As each level of option gets further in-the-money, the delta of the options purchased will become greater than the delta of the options sold. In other words, the further an option is in-the-money, the more it acts like a stock. 



FIGURE  Put Ratio Backspread Risk Profile

Put Ratio Backspread Case Study

In this case, it’s February 2004 and we’re worried that the stock is due for a sharp fall. However, if we’re wrong, we don’t want to lose our shirt. The stock is trading for exactly $30 a share and we set up a 1-to-2 put ratio backspread composed of the purchase of two INTC January 2005 25 puts @ $1.50 and the sale of one January 2005 30 put @ $3.50. The trade yields a $50 credit. If the stock rallies rather than falls, we can do nothing, keep the credit, and let the puts expire worthless. Ideally, however, the stock will move below the downside breakeven. 

At expiration, the downside breakeven is equal to the lower strike price minus the difference in strike prices times the number of short puts plus the credit, which equals $20.50: $25 – (5 × 1) + .50 = $20.50. The maximum risk occurs if the stock closes at the lower strike price at expiration. At that point, the short call is $5 in-the-money, but the long call expires worthless. However, just as with the call ratio backspread, we do not want to hold this position until expiration. Instead, we want to exit the position 30 days before expiration or after a reasonable profit. 


FIGURE  INTC Put Ratio Backspread 

EXIT STRATEGIES FOR RATIO BACKSPREADS

Whether trading call or put ratio backspreads, the strategist wants to consider the possibility of early assignment on the short options. This can occur if the short options have little time value left. As a general rule, an option with a quarter point or less of time value will have a relatively high probability of assignment. At that point, it might be wise to close the backspread. In addition, we generally recommend exiting ratio backspreads 30 days prior to the options’ expiration. Here are a few exit rules to follow when dealing with put or call backspreads. First, if the trade has a reasonable profit (50 percent or more), consider closing out an equal number of short and long positions. 

Then, the remaining long option is working with free money and can be held for additional profits.  Second, if the underlying stock rises between the upside and downside breakevens, exit the entire position with 30 days or less left until expiration. To do so, buy the short options back and sell the long options. In that case, try to mitigate the loss. Third, it is recommended that you close out the position before 30 days of expiration unless you feel strongly that the stock will continue to increase (in a call backspread) or decrease (in a put backspread). If the underlying stock falls below the downside breakeven in a call ratio backspread or above the upside breakeven in a put ratio backspread, let the options expire worthless.

VOLATILITY SKEWS

There are two types of volatility skews that can develop in an options class. The first type is known as a time skew and arises when the implied volatility of one month is significantly different from the other months. This often happens when there is a takeover rumor or some other event that causes the implied volatility of the short-term options to move higher relative to longer-term options. When this happens, the strategist can attempt to take advantage of the time skew with a calendar spread, which involves buying the options with the low implied volatility (IV) and selling the options with the high IV. The strike prices of the two options contracts are the same, but the expiration months are different. 

The second type of volatility skew is known as a price skew. With this type of skew, the expiration months are the same. However, there is a significant difference in implied volatility along the various strike prices. For example, if the at-the-money options have a much higher implied volatility than the out-of-the-money options, the result is a price skew. Going further, there are two types of price skews. With a forward price skew, the options with the higher strike prices have higher levels of implied volatility than the options with lower strike prices. A reverse volatility skew, in contrast, occurs when the lower strike prices have a higher volatility skew than the options with the higher strike price.

Traders can sometimes use forward and reverse volatility skews to their advantage. The goal is to sell those options with the higher implied volatility and buy the ones that have the lower IV because the ones with the higher implied volatility are considered more expensive. For instance, if a strategist identifies a forward volatility skew, they can attempt to profit with a put ratio backspread, which involves buying the options with the lower strike price and selling the options with the higher strikes. Call ratio backspreads make more sense when the strategist identifies a reverse skew. At that point, they would want to sell the options with the lower strike price and buy a greater number of the higher strike options.

STRATEGY ROAD MAPS

Ratio Call Spread Road Map

In order to place a call ratio spread, the following 12 guidelines should be observed:

1. Look for a market where you expect a decline (to keep the net credit) or a slight rise not to exceed the strike price of the short options.

2. Check to see if this stock has options available.

3. Explore past price trends and liquidity by reviewing price and volume charts over the past year.

4. Review options premiums per expiration dates and strike prices. Place the position as a credit or as close to at-even as you can. Use options with greater than 90 days until expiration. LEAPS options are a good choice since they provide an opportunity for time to work in your favor.

5. Investigate implied volatility values to see if the options are overpriced or undervalued. This strategy is best placed in markets with a reverse volatility skew. In this environment, the higher strike options (the ones you want to sell) have higher implied volatility and can be overpriced. The lower strike options (the ones you want to buy) enjoy lower implied volatility and are often underpriced. By trading the reverse volatility skew, you can capture the implied volatility differential between the short and long options.

6. A ratio call spread is composed of buying the lower strike call (ITM or ATM) and selling a greater number of higher strike calls (OTM). Determine which spread to place by calculating:

Unlimited Risk: Unlimited to the upside above the breakeven.
Limited Reward: Limited. [Number of long contracts × (difference in strikes × 100)] + net credit (or – net debit).
Upside Breakeven: Lower call strike price + [(difference in strikes × number of short contracts) ÷ (number of short calls – number of long calls)] + net credit (or – net debit).
• Downside Breakeven: None when established for a credit.

7. Create a risk profile of the most promising option combination and graphically determine the trade’s feasibility. A call ratio spread risk profile shows an unlimited risk above the upside breakeven and a limited reward.

8. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

9. Make an exit plan before you place the trade. How much money is the maximum amount you are willing to lose? How much profit do you want to make on the trade? For example, exit the trade when the stock moves above the maximum profit level at any time prior to 30 days before expiration.

10. Contact your broker to buy and sell the chosen options. Place the trade as a limit order so that you limit the net credit/debit of the trade.

11. You do have to watch the market closely on this type of trade. The profit on this strategy is limited, but the risk is unlimited.

12. Choose an exit strategy based on the price movement of the underlying stock and fluctuations in the implied volatility of the options:

• The underlying stock exceeds the short strike price: Once the stock has made a move higher, watch carefully for any further moves higher. Exit the strategy if the stock moves either (1) above the maximum profit level or (2) above the upside breakeven.
• The underlying stock falls below the downside breakeven: Keep the credit and let the options expire.

Ratio Put Spread Road Map

In order to place a ratio put spread, the following 12 guidelines should be observed:

1. A ratio put spread can be implemented when a slight fall in the market is anticipated followed by a sharp rise.

2. Explore past price trends and liquidity by reviewing price and volume charts over the past year.

3. Check to see if this stock has options available.

4. Review options premiums per expiration dates and strike prices.

5. Investigate implied volatility values to see if the options are overpriced or undervalued. This strategy is best placed in markets with a forward volatility skew. In this environment, the lower strike options (the ones you want to sell) have higher implied volatility and can be overpriced. The higher strike options (the ones you want to buy) have lower implied volatility and are often underpriced. By trading this type of volatility skew, you can capture the implied volatility differential between the short and long options.

6. A ratio put spread is created by buying a higher strike put (ITM or ATM) and selling a greater number of lower strike puts (OTM). Determine which spread to place by calculating:

• Limited Risk: Limited to the downside below the breakeven as the stock can only fall to zero. Lower strike price – (difference in strikes – net credit) × 100. Although limited, the risk can be significant.
• Limited Reward: Limited. (Difference in strikes × 100) + net credit (or – net debit].
• Upside Breakeven: None.
• Downside Breakeven: Higher strike price – [(difference in strikes × number of short contracts) ÷ (number of short contracts – number of long contracts)] – net credit (or + net debit).

7. Create a risk profile of the most promising option combination and graphically determine the trade’s feasibility.

8. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

9. Make an exit plan before you place the trade. If the stock falls below the maximum profit point, consider closing the position. The position begins losing money if it falls below the breakeven.

10. Contact your broker to buy and sell the chosen options. Place the trade as a limit order so that you limit the net credit/debit of the trade.

11. You do have to watch the market closely on this type of trade. Losses can be substantial if the stock falls sharply.

12. Choose an exit strategy based on the price movement of the underlying stock and fluctuations in the implied volatility of the options:

• If the underlying stays the same or rises: Do nothing, let the puts expire worthless and keep the net credit.
• The underlying stock falls below the short strike price: You should consider exiting the entire position for a small gain.
• The underlying stock falls below the downside breakeven: You should close the position and take the loss.

Call Ratio Backspread Road Map

In order to place a call ratio backspread, the following 14 guidelines should be observed:

1. Look for a bullish market where you anticipate a large increase in the price of the underlying stock. Choose stocks that are leaders in their fields and have an increasing stream of earnings and quarter-over-quarter growth.

2. Check to see if this stock has options available.

3. Explore past price trends and liquidity by reviewing price and volume charts over the past year.

4. Review options premiums per expiration dates and strike prices. Place the position as a credit or as close to at-even as you can. Use options with greater than 90 days until expiration. LEAPS options are a good choice since they provide ample opportunity for time to work in your favor.

5. Investigate implied volatility values to see if the options are overpriced or undervalued. This strategy is best placed in markets with a reverse volatility skew. In this environment, the lower strike options (the ones you want to sell) have higher implied volatility and can be overpriced. The higher strike options (the ones you want to buy) enjoy lower implied volatility and are often underpriced. By trading the reverse volatility skew, you can capture the implied volatility differential between the short and long options.

6. A call ratio backspread is composed of selling the lower strike call (ITM or ATM) and buying a greater number of higher strike calls (OTM). It is not usually recommended to place positions with ratios greater than .67; use ratios that are a multiple of 1-to-2 (the most common) or 2-to-3. All options must have the same expiration date.

7. Look at options with at least 90 days until expiration to give the trade enough time to move into the money.

8. Determine which spread to place by calculating:

• Limited Risk: Limited. [(Number of short calls × difference in strikes) × 100] – net credit (or + net debit).
• Unlimited Reward: Unlimited to the upside above the upside breakeven.
• Upside Breakeven: Higher strike call + [(difference in strikes × number of short calls) ÷ (number of long calls – number of short calls)] – net credit (or + net debit).
• Downside Breakeven: Lower strike price + (net credit ÷ number of short calls)]. A downside breakeven does not exist if the trade is entered with a net debit.

9. Create a risk profile of the most promising option combination and graphically determine the trade’s feasibility. A call ratio backspread risk profile shows an unlimited reward above the upside breakeven and a limited reward (if entered for a net credit) below the downside breakeven.

10. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

11. Make an exit plan before you place the trade. How much money is the maximum amount you are willing to lose? How much profit do you want to make on the trade? For example, exit the trade when you have a 50 percent profit or at least 30 days prior to expiration on the options before the major amount of time decay occurs.

12. Contact your broker to buy and sell the chosen options. Place the trade as a limit order so that you limit the net debit of the trade.

13. You do not have to watch the market closely on this type of trade. The profit on this strategy is unlimited.

14. Choose an exit strategy based on the price movement of the underlying stock and fluctuations in the implied volatility of the options:

• The underlying stock exceeds the upside breakeven: Once you have made a reasonable profit (50 percent), you should close out an equal number of short calls and long positions. Since the remaining long option is now working with free money, you can afford to hold onto it for additional profit. It is recommended that you close out the position before 30 days to expiration unless you feel strongly that the stock will continue to increase.
• The underlying stock rises between the upside and downside breakevens: You should exit the entire position—buy the short calls back and sell the long calls—and try to mitigate the loss.
• The underlying stock falls below the downside breakeven: Let the options expire worthless, or sell the long call at expiration to mitigate any losses.

Put Ratio Backspread Road Map

In order to place a put ratio backspread, the following 14 guidelines should be observed:

1. Look for a bearish, low implied volatility market where you anticipate a sharp decline in the price of the underlying stock with increased volatility.

2. Explore past price trends and liquidity by reviewing price and volume charts over the past year.

3. Check to see if this stock has options available.

4. Review options premiums per expiration dates and strike prices. Ideally use options with at least 90 days until expiration. LEAPS options are also a good alternative for put ratio backspreads.

5. Investigate implied volatility values to see if the options are overpriced or undervalued. This strategy is best placed in markets with a forward volatility skew. In this environment, the higher strike options (the ones you want to sell) have higher implied volatility and can be overpriced. The lower strike options (the ones you want to buy) enjoy lower implied volatility and are often underpriced. By trading the forward volatility skew, you can capture the implied volatility differential between the short and long options.

6. A put ratio backspread is created by selling a higher strike put (ITM or ATM) and buying a greater number of lower strike puts (OTM). It is not recommended to place positions with ratios greater than .67. Use ratios that are a multiple of 1 to 2 (the most common) or 2 to 3. All options must have the same expiration date.

7. Look at options with at least 90 days until expiration to give the trade enough time to move into the money.

8. Determine which spread to place by calculating:

• Limited Risk: [(Number of short puts × difference in strikes) × 100] – net credit or + net debit.
• Limited Reward: Limited to the downside below the downside breakeven (as the underlying can only fall to zero).
• Upside Breakeven: Higher strike put – (net credit ÷ number of short puts). An upside breakeven does not exist if the trade is entered with a net debit.
• Downside Breakeven: Lower strike price – [(number of short puts × difference in strikes) ÷ (number of long puts – number of short puts)] + net credit (or – net debit).

9. Create a risk profile of the most promising option combination and graphically determine the trade’s feasibility.

10. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

11. Make an exit plan before you place the trade. How much money is the maximum amount you are willing to lose? How much profit do you want to make on the trade? For example, exit the trade when you have a 50 percent profit or at least 30 days prior to option expiration.

12. Contact your broker to buy and sell the chosen options. Place the trade as a limit order so that you limit the net credit/debit of the trade.

13. You do not have to watch the market closely on this type of trade. The profit on this strategy is unlimited.

14. Choose an exit strategy based on the price movement of the underlying stock and fluctuations in the implied volatility of the options:

• The underlying stock falls below the downside breakeven: Once you have made a reasonable profit (50 percent +), you should close out an equal number of short and long puts. Since the other long option is now working with free money, you can afford to hold onto it for additional profit. It is recommended that you close out the position before 30 days until expiration unless you feel strongly that the stock will continue to decrease.
• The underlying stock rises between the downside and upside breakevens: You should exit the entire position and take the loss.

CONCLUSION

Ratio backspreads are great strategies that when ideally placed provide a credit for the position with unlimited reward potential. In general, these type of strategies consist of selling one or more options that are at-the-money and simultaneously buying a larger number of options that are further out-of-the-money where all options have the same expiration date and underlying stock or index.

Ratio backspreads are quite popular. The key to finding one lies in identifying the correct volatility conditions that will allow you to place them for a credit (or even).Vacation trading criteria include the following issues.

• Look for a market where you anticipate a large directional move:
   • Up with a reverse volatility skew—call ratio backspreads.
   • Down with a forward volatility skew—put ratio backspreads.
• Buy and sell options with at least 90 days or greater till expiration. LEAPS are ideal as the time factor will work for you.
• Once you are deep in-the-money, you may want to consider an adjustment by closing out one long and one short position and continuing to hold one long position.
• Exit strategy: Look for your target profit and exit before 30 days to expiration. Your maximum risk is usually very low, so you can chose to stay in the trade and look for a turnaround or get out before a large percentage loss.

Volatility plays a key role in ratio backspreads. By searching for the right volatility combination you can create a position that gives you a high probability for a healthy reward. Developing a good feel for volatility is an important part of being able to pick the right market and the optimal strategy. Markets that go up rapidly most likely will come down fast. The faster they go down, the faster they go up. If you are in a market that is going straight to the moon, start looking for opportunities for put ratio backspreads. Why? When the markets are going straight up, traders pump up the call prices because of increased volatility. 

This also means that the market may very well be positioning itself for a severe correction to the downside.  Many times you can get better prices on the put side of a trade, because people tend to buy calls when volatility increases. There is simply a greater demand for calls in a fast-moving market to the upside. If the market is going down and you expect continuation, do a put ratio backspread. If you expect a reversal, do a call ratio backspread. The best way to learn how these strategies react to market movement is to experience them by paper trading markets that seem promising. 

Once you have initiated a paper trade, revisit the trade every week to learn how market forces affect these kinds of limited risk/unlimited reward strategies. One of the most important actions in trading is exiting a trade. Paper trading is also a practical way of learning how to exit a trade by monitoring the market for profits or losses. Any fictitious losses can be chalked up to experience (rather than a real loss) and all winning trades will inspire confidence.

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