A Bear Put Ratio Backspread 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 two puts 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 one sold 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.
Put Ratio Backspread Profit & Loss Graph
The following is the profit/loss graph at expiration for the Bear Put Ratio Backspread in the example given on the previous page.
The breakeven point for the bear call ratio backspread is given next:
- Breakeven Stock Price1 = Sold Call Option Strike Price – Net Premium Sold (Cost of Options Sold – Cost of Options Purchased). Note: This breakeven might not exist with every bear put ratio backspread a trader trades (i.e. if there is net premium purchased rather than sold).
- Breakeven Stock Price2 = Sold Call Option Strike Price – 2 x Distance between strike prices of the call sold and the calls purchased + Net Premium Sold or – Net Premium Purchased.
To illustrate, the trader sold the $50.00 strike price put option for $1.34, and also bought two options at the $47.50 strike price for $0.44 each, for a net premium sold of $0.46 ($1.34 – $0.88). The strike price sold was the $50.00. Therefore, $50.00 – $0.46 = $49.54. The trader will breakeven, excluding commissions/slippage, if the stock is above $49.54 by expiration.
For the second breakeven, the distance between the two strike prices is $2.50 ($50.00 – $47.50). Consequently, 2 times $2.50 is $5.00. The net premium sold was $0.46. The sold put option strike price is $50.00. Summing everything together, $50.00 – $5.00 + $0.46 = $45.46. As such, the two breakeven points are $45.46 and $49.54.
The profit for a bear put ratio backspread is as follows:
- Bear Put Ratio Backspread Profit = Breakeven price – Stock price at expiration
To continue the example, if the stock price at expiration is $44.00, then the profit would be $146 [($45.46 – $44.00) x 100 shares/contract].
To the upside, the max profit is $46 anywhere above the strike price of the option sold. This profit area to the upside might not exist for all bear put ratio backspreads.
A partial loss occurs between the put strike price sold and the put strike price purchased. A partial loss also occurs between the point of max loss and the downside breakeven. The calculation is given next:
- Bear Put Ratio Backspread Partial Loss1 = (Strike Price of Option Sold – Stock Price at Expiration) – Net Premium Sold or + Net Premium Purchased
For example, if the stock price was $48.00 at expiration and the strike price of the option sold is $50.00 and net premium sold was $0.46, then [($48.00 – $50.00) + $0.46] x 100 shares/contract = $154 loss.
- Bear Put Ratio Backspread Partial Loss2 = (Downside Breakeven Stock Price – Stock Price at Expiration)
To illustrate, if the stock price at expiration was $47.00 and the downside breakeven stock price was $45.46, then [($45.46 – $47.00) x 100 shares/contract] = $154 loss.
As stated previously, the max loss occurs at the strike price of the puts purchased. The formula is as follows:
- Bear Put Ratio Backspread Max Loss = (Strike price of put sold – Strike price of puts purchased) + Net Premium Purchased or – Net Premium Sold.
As an example, the strike price of the puts purchased is $47.50, the strike price of the put sold is $50.00, and the net premium sold is $0.46: ($50.00 – $47.50) – $0.46 = $2.04 x 100 shares/contract = $204.
Bear Put Ratio Backspread vs Put Option
Both the profit/loss graph at expiration for the Bear Put Ratio Backspread and a Put are given below.
The put is superior than the bear put ratio backspread when it comes to the better downside breakeven.
- Bear Put Ratio Backspread = $45.46
- Put = $47.06
The profit for a bear put ratio backspread is less than a put. The profit at a stock price of $45 is given below :
- Bear Put Ratio Backspread = $46
- Put = $206
At a stock price of $50 (i.e. stock did not move in 30 days) the bull call ratio backspread actually makes money, whereas the put loses money:
- Bear Put Ratio Backspread = $46
- Put = -$44
However, at a price of $47.50, the bear put ratio backspread is very inferior to the put.
- Bear Put Ratio Backspread = -$204
- Put = -$44
Like all option strategies, the trader's exact expectations have to be considered when deciding the best strategy to use:
- Direction of stock move
- Magnitude (size) of stock move
- Time frame of stock move