Back Spread with Puts (Ratio Volatility Spread)

Overview

Remember the Call Back Spread? Well, meet its bearish twin – the Put Back Spread. This strategy is for when you're feeling particularly gloomy about a stock's prospects but want to limit your risk while still having explosive profit potential if things really go south.

The Put Back Spread (also called a Ratio Volatility Spread or Pay Later Put) involves selling one put option at a higher strike price and buying two or more put options at a lower strike price, all expiring on the same day. It's like buying disaster insurance and getting someone else to help pay for it. The put you sell helps finance the multiple puts you buy, giving you leveraged exposure to a potential downside collapse.

Key Characteristics

• Market Outlook: "I think this stock is about to crash, and I want cheap tickets to profit from the disaster"
• Risk: Limited to a specific zone – your maximum pain point happens with a moderate price decrease
• Profit Potential: Substantial if the stock really tanks
• Breakeven Points: Two of them – one near your short put strike and another below your long put strikes

When to Use

The Put Back Spread might be your strategy of choice when:

• You've got a strong hunch a stock is about to take a serious nosedive
• You think market volatility is about to increase (maybe before earnings or bad news)
• You want to swing for the fences on the downside without risking too much capital
• You're looking for a way to potentially set up a bearish position for very little cost (sometimes even for free)
• You want substantial downside profit potential with limited upside risk

Real-World Example

Let's walk through this with a concrete example. Say XYZ stock is trading at $50, and you think it might be about to announce something terrible that could send the stock plummeting.

• You sell 1 put with a $50 strike price for $3 per share ($300 total) – this generates cash
• You use that cash to buy 2 puts with a $45 strike price for $1.25 each ($250 total)
• Your net cost? Just $50 for the whole position ($0.50 per share) – that's your total risk if the stock does nothing

Now let's see what happens in different scenarios:

• If XYZ stays around $50: All options expire worthless, and you lose your $50 investment. Not too painful!
• If XYZ drops to $45: This is actually your worst-case scenario. Your short $50 put costs you $500, while your long $45 puts expire worthless. Your total loss is $550 ($500 plus your initial $50 investment).
• If XYZ drops to $40: Your short $50 put costs you $1,000, but your two $45 puts are worth $500 each ($1,000 total). You break even (minus your initial $50 investment).
• If XYZ crashes to $30: Your short $50 put costs you $2,000, but your two $45 puts are worth $1,500 each ($3,000 total). You make a $950 profit after subtracting your initial $50 investment!

The beauty here? The further the stock falls, the more money you make – and you only risked $50 to begin with! It's like betting a small amount on a horse with long odds, but with a much better chance of winning.

The Good Stuff

• Substantial profit potential if the stock crashes
• Limited risk – you know exactly the most you can lose
• Can sometimes be set up for free or even a small credit (getting paid to place the trade!)
• If implied volatility increases after you enter the position, both your long puts benefit
• You get more leverage than simply buying puts outright
• Works well when you expect a major negative catalyst but don't want to risk too much

The Not-So-Good Stuff

• It's a bit complex – this isn't a beginner's strategy
• Your maximum loss happens with a moderate price decrease – exactly when you might think you should be making money
• You need a really big move to be profitable – small drops won't cut it
• Time decay works against your long puts if the stock doesn't move quickly
• If volatility decreases after you enter, your long puts lose value faster than your short put

Playing It Smart

• Choose your strike prices carefully – the wider apart they are, the more the stock needs to move for profitability
• Consider using a higher ratio (like 1:3) for more explosive downside, though this usually costs more to set up
• Time your entry before events that might trigger big price drops (earnings misses, FDA rejections, etc.)
• Have an exit plan if the stock moves to your maximum loss zone (around your long put strike)
• Look for situations where implied volatility is relatively low but you expect it to increase
• Remember that this is a "home run" strategy – you'll strike out often, but when you connect, the ball can go very far
• Be careful about using this on stocks that might be acquisition targets – unexpected good news can hurt this position