Ratio Put Backspread
Strategy DetailsStrategy Type : Bearish
# of legs : 3 (Short 1 Higher Strike Put + Long 2 Lower Strike Puts)
Maximum Upside Reward : Limited to the extent of Net Premium Received
Maximum Downside Reward : Unlimited, once the underlying crosses below the lower breakeven point
Maximum Risk : Higher Strike Price - Lower Strike Price - Net Premium Received
Upper Breakeven Price : Higher Strike Price - Net Premium Received
Lower Breakeven Price : Lower Strike Price - Difference between Higher and Lower Strike + Net Premium Received
Payoff Calculation : Payoff of Short Put+ (2 * Payoff of Long Put)
In the above table, we have assumed the traditional 2:1 ratio wherein the trader is buying 2 Puts and selling 1 Put. However, note that this strategy can be executed using other combinations as well. The most commonly used long-short ratio is 2:1 followed by 3:2. For our discussion henceforth, we will assume a total of 3 legs i.e. 1 Put short at a higher strike and 2 Puts long at a lower strike.
Explaination of the Strategy
A Ratio Put Backspread is a strategy that involves selling a higher strike Put and simultaneously writing two lower strike Puts having the same strike, underlying, and expiration. As this strategy involves buying a greater number of Puts than selling, this is pre-dominantly a bearish strategy that benefits from a sharp decline in the price of the underlying instrument. Usually, this strategy is executed as a net credit strategy, because doing so enables the trader to make a small gain even if the underlying price moves higher. That said, this strategy can be executed as a net debit strategy as well. For our further discussion, we will be assuming this to be a net credit strategy.
The Ratio Put Backspread has two breakeven points: upper and lower. The strategy benefits if the underlying price is either above the upper breakeven point or below the lower breakeven point. If the underlying price is above the upper breakeven point, maximum profit is limited to the extent of net premium received. On the other hand, if the underlying price is below the lower breakeven point, maximum profit is potentially unlimited. Because of this feature, this is primarily a bearish strategy that must be deployed only when one is very bearish on the underlying and expects it to slump below the lower breakeven point. Meanwhile, the trader suffers a loss if the underlying price gets stuck between the two breakeven points. Maximum loss under this strategy occurs when the underlying is exactly at the lower strike price.
This strategy is highly attractive from a risk/reward perspective because of its limited risk-unlimited reward potential. However, remember that for this strategy to make money, the underlying price will either have to stay above the upper breakeven point or fall below the lower breakeven point. If it gets stuck between the two, the trader will suffer a loss. Hence, it is necessary to keep this in mind when executing this strategy so as to select the right strikes. Also, as this strategy benefits from a sharp move lower in the underlying price, ensure to select the underlying when it is exhibiting volatility, as high volatility is highly beneficial to this strategy.
Benefits of the Strategy
· This is usually a net credit strategy that requires no upfront payment
· If this is executed as a net credit strategy, it can profit from an up move in price as well
· This strategy has an unlimited profit potential in case the underlying falls sharply
· This strategy has limited risk
Drawbacks of the Strategy
· Any stagnation in the underlying price between the two breakeven points will lead to losses
· Because this strategy involves selling an option, it will require a greater margin in your trading account
· Ensure that the trend is bearish and that you have conviction that the underlying price will fall sharply going forward
· Keep in mind that the number of Puts bought must exceed the number of Puts sold. The ideal long-short ratio for this strategy is 2:1 and to some extent even 3:2.
· When choosing strikes, don’t just randomly select any strike. Remember, you want the underlying price to fall beyond the lower breakeven point, so select strikes accordingly and realistically
· The difference between the lower strike and the higher strike will be a trade-off between net credit and risk
· The wider the difference between the two strikes, the larger would the net credit be but so would be the risk, and vice versa. This is because the wider the difference, the farther will the lower breakeven point be, meaning the larger will be the loss-making zone
· Because this strategy benefits the most when the underlying price falls sharply, ensure that the underlying instrument being chosen for this strategy is exhibiting volatility
· Because you have more long Puts than short Puts, Theta will work against you, especially as the underlying price starts falling and inches closer towards the strike of the long Puts
· Because you have a greater number of long Puts than short Puts and because you want the underlying price to fall sharply, give yourself sufficient time to go right by selecting options that have ample life left
· If there is less time left to expiration and if you still want to deploy this strategy, it would be wiser to execute this as a net debit strategy, so as to narrow the difference between the two strikes
· Ensure there is sufficient liquidity in the underlying that is being chosen to initiate this strategy
Option Greeks for Ratio Put Backspread
Greek Notes Delta : Delta is usually positive at initiation, meaning a rise in the underlying price will benefit the option position. However, if the underlying price drops and moves below the upper breakeven point, Delta will start turning negative, which means a fall in the underlying price will now start benefiting the position, and vice versa.
Gamma : Gamma is initially negligible or slightly negative when the underlying price is at or near the higher strike. It starts rising as the underlying price falls and moves awayfrom the higher strike. This causes the Delta to turn negative and move lower. Gamma eventually peaks out near the lower strike and starts tapering after that. As a result, once the underlying drops below the lower strike, Delta continues declining but at a slower rate as it approaches its lower extreme.
Vega : When the underlying price is above the upper breakeven point, Vega is negative because of which rising volatility hurts the position, and vice versa. However, when the underlying price drops below the upper breakeven point, Vega turns positive because of which rising volatility starts benefiting the position, and vice versa. Vega tends to peak out near the lower strike, below which it starts declining, meaning the impact of volatility on option position will start reducing once the underlying price drops below the lower strike price.
Theta : When the underlying price is above the upper breakeven point, Theta is positive because of which time decay benefits the position. However, when the underlying price drops below the upper breakeven point, Theta turns negative because of which time decay starts hurting the position. Theta bottoms out near the lower strike, meaning it is at this point where the negative impact of time decay is the highest. Once the underlying price declines below the lower strike, the two long Puts become ITM, because of which the impact of Theta gradually starts tapering.
Rho : As this strategy involves buying two Puts as opposed to writing one Put, Rho turns negative as the underlying price falls and approaches the lower strike. As a result, rising interest rates can hurt the position at lower levels. That said, this is the least significant of the Greeks, especially in case of short-dated options.
Payoff of Ratio Put Backspread
The chart below shows the payoff of the Ratio Put Backspread strategy. This strategy has two breakeven points: upper and lower. The region outside the two breakeven points is the profit-making zone, while the region within the two breakeven points is the loss-making zone. As we can see in the chart, as long as the underlying price is at or above the higher strike, the trader gets to keep the entire net premium that he/she has received upfront. Similarly, if the underlying price drops below the lower breakeven point, the trader has the potential to earn unlimited profit, depending on how lower the underlying price falls below the lower breakeven point. Meanwhile, the maximum loss under this strategy occurs when the underlying price is exactly at the lower strike price.
Example of Ratio Put Backspread
Let us say that Mr. ABC is very bearish on the short-term outlook of Reliance Industries, based on which he has decided to initiate a Ratio Put Backspread strategy, wherein he will sell 1 ITM 1220 Put at ₹80 and buy 2 OTM 1100 Puts at ₹30 each. Let us summarize the details of the strategy below:
Strike price of shortPut = 1220
Strike price of longPut = 1100
Quantity of Puts sold = 1 lot
Quantity of Puts bought = 2 lots
ShortPut premium (higher strike) = ₹80
Long Put premium (lower strike) = ₹30
Net Credit = ₹20 (80 - 2 * 30)
Net Credit (in value terms) = ₹10,000 (20 * 500)
Upper breakeven point = 1200 (1220 - 20)
Lower breakeven point = 1000 (1100 - 120 + 20)
Maximum upside reward = ₹10,000
Maximum downside reward = unlimited
Maximum risk = ₹50,000 ((1220 - 1100 - 20) * 500)