Put Ratio Backspread

Overview

If you thought the Call Ratio Backspread was interesting but you're feeling bearish instead of bullish, the Put Ratio Backspread might be right up your alley. This strategy is like having your cake and eating it too in a down market – you get to bet on a stock dropping while actually making money if it just sits still.

Here's the twist: you buy a put at a lower strike price and sell multiple puts (typically two) at a higher strike price. This flips the risk profile in an interesting way, giving you profits in more scenarios but with some unique risks. Think of it as a bearish strategy with training wheels – you can still win big if the stock tanks to a certain level, but you've got some protection if it doesn't move much.

Key Characteristics

• Market Outlook: "I think this stock is heading down, but I want to make money even if I'm wrong"
• Risk: Limited, but your worst-case scenario happens if the stock crashes too far
• Profit Potential: Substantial if the stock falls to just the right level
• Breakeven Points: Usually two of them – one where the stock doesn't move much and another if it falls substantially

When to Use

The Put Ratio Backspread might be your strategy of choice when:

• You're bearish on a stock but want some profit even if it doesn't move much
• You think volatility might increase (maybe before earnings or negative news)
• You want to limit your risk while still having substantial downside potential
• You're looking for a strategy that can make money in multiple scenarios
• You want a more forgiving approach than a simple directional bet

Real-World Example

Let's walk through this with a concrete example. Say XYZ stock is trading at $50, and you think it has good downside potential but you're not 100% confident.

• You buy 1 put with a $40 strike price (out-of-the-money) for $1 per share ($100 total)
• You sell 2 puts with a $45 strike price (closer to the money) for $2 each ($400 total)
• Your net credit is $300 for the whole position ($3 per share) – that's cash in your pocket right away!

Now let's see what happens in different scenarios:

• If XYZ stays above $45: All options expire worthless, and you keep your entire $300 credit. Free money!
• If XYZ falls to $45: The two $45 puts are at-the-money but have no intrinsic value yet, and your $40 put is still worthless. You still keep your $300 credit.
• If XYZ falls to $40: The two $45 puts are now worth $5 each ($1,000 total), while your $40 put is at-the-money with no intrinsic value. Your net position costs you $700, but since you received $300 upfront, your total loss is $400.
• If XYZ falls to $35: The two $45 puts are worth $10 each ($2,000 total), while your $40 put is worth $5 ($500). Your net position costs you $1,500, minus your $300 credit, for a total loss of $1,200.

The fascinating thing here? Your maximum profit occurs when the stock stays above your short put strike, and your maximum loss happens if the stock crashes too far. It's like a bearish strategy with a built-in safety net for moderate drops, but with a catch if things get too extreme.

The Good Stuff

• You often receive money upfront (a credit) when establishing the position
• You profit if the stock stays flat or falls just a little – a pretty forgiving scenario
• Your risk is defined and limited, though it can be substantial
• If implied volatility increases after you enter, your long put benefits
• It's a clever way to express a bearish view without needing the stock to crash immediately

The Not-So-Good Stuff

• It's a complex strategy with a counterintuitive risk profile – not for beginners
• You can actually lose money if the stock falls too much – a weird outcome for a bearish strategy
• You need to monitor the position closely as the stock approaches your short put strikes
• The maximum loss can be substantial if the stock crashes well below your long put strike
• If volatility decreases after you enter, your long put loses value faster than your short puts

Playing It Smart

• Choose your strike prices carefully – they determine your profit zones and maximum loss area
• Consider different ratios (like 1:3) for different risk/reward profiles
• Have an exit plan if the stock falls below your short put strike but hasn't reached your long put strike
• Be especially cautious about earnings announcements or other events that might cause the stock to gap down significantly
• Remember that this strategy has a "sweet spot" – if the stock falls too far, you can lose money
• Consider closing the position early if the stock starts to fall rapidly past your short put strike
• Don't get greedy – if you've collected your maximum credit and the stock is behaving as expected, it might be wise to take your profits and move on