All the strategies in stock markets that traders use to build their positions are based on the view they hold about markets. As the views change time and again, so do the strategies and consecutively the positions of their trades. When traders hold a bullish view on the stock or the index, one of the many strategies they use to enter into bullish trades is the call ratio back spread strategy. Similarly, when the view on stock or markets, in general, is bearish, the put ratio back spread strategy is useful to them.
So let us know about what exactly is the bearish ratio back spread, how it is to be built, the pay-off schedule, risk management along an example.
Put Ratio Back Spread
A put ratio backspread is a strategy that uses buying puts as well as selling them to create a position with a potential to gain from it. The potential to gain or lose from this setup completely depends on the ratio in which a trader builds long and short positions in the put options.
How to build a Put Ratio Back Spread?
When your outlook on a particular stock or the index is bearish, you can build this strategy for potential gain from the situation as follows.
- Sell one at or in the money put option
- Buy two out of money put options
If you want to increase the quantity, you must add up the position in the same ratio. The essence of this strategy is in the term ‘ratio’. In the above method, we have used a 1:2 ratio to build put ratio back spread. Some traders also use a 1:3 ratio where one put option is sold and three put options are bought.
Risk Management in this Strategy
The risk of making a loss always remains in any strategy. But when you are expecting a major fall in the stock price or the index, then this strategy can give you limited loss and unlimited potential gains if your analysis goes in the right direction and prices fall majorly.
It can easily be concluded that risk in this method is limited and potential gains could be unlimited since the double quantity of options is bought to benefit from the major price movement.
Understand Put Ratio Back Spread with an Example
Let us assume a hypothetical situation of Stock A and understand this strategy taking into consideration the following particulars:
|Current Market Price of Stock A||Rs. 500|
|Lot Size||100 shares|
Below-mentioned put options are available:
|500 Put Option (ATM)||Rs. 20|
|480 Put Option (OTM)||Rs. 10|
To build this ratio back spread, you will sell one at the money put option that is the 500 strike price put option in this case, and collect a premium of Rs. 2,000 (Rs. 20 x 100 shares).
Simultaneously, you will also buy two lots of out-of-money put options that are the 480 put options in this case, and pay a total premium of Rs. 2,000 (Rs. 10 x 100 shares x 2 lots).
So the net credit or debit of the premium is 0. You collected Rs. 2,000 and paid Rs. 2,000.
Now if the price of Stock A ends at Rs. 500 or anywhere above that level on the day of expiry, you will be at breakeven without any gain or loss. Another breakeven for you would be Rs. 460. Even if the stock price ends at that level, you will have no profit or loss.
To understand the position of profit or loss at different price levels in a better way, we need to analyze it by making a pay-off schedule.
The Pay-off Chart
Continuing with the above example, let us build a pay-off chart based on where the price of Stock A could end up in different scenarios.
|Stock Price on Expiry||Pay-off from Put Short||Pay-off from Put Long||Net Pay-off|
So the scenario of unlimited gains and limited loss is apparent from this pay-off chart. This table must have helped you understand the working of put ratio back spread in a better way.
Effects of Option Greek on This Strategy
Options Greeks are a set of calculations that you can use to measure the difference between the prices of various options contracts. The three main Greeks that have its impact on the ratio backspread.
The Delta would be negative if the net premium is paid, which means that any upside movement would result in loss, while a big downside movement would lead to unlimited profit.
The theta refers to time decay in options premium prices. Hence, this harms backspread strategy since two lots of put options are purchased.
In this method, the position of Gamma is long. This implies that a fall in stock price or index value would be more beneficial as per the strategy.
You can enter into this strategy when you are bearish on the stock or index. If the 1:2 ratio is followed, then you must sell one put option and buy two put options. Some traders also follow a 1:3 ratio. But it is advisable to calculate the risk by drawing a pay-off chart before entering into the trades using this strategy. As per the positioning of trades, a trader can make less or no money if prices go up or don’t fall but may gain more if the prices fall significantly.