Put Ratio Back Spread Strategy
After covering the 'Call Ratio Back spread strategy' in the last unit, next, we will learn the 'Put Ratio Back Spread Strategy.'
The Put ratio back spread is similar except that the traders view is bearish on the market or stock.
When do we initiate a Put Ratio Back spread strategy?
This strategy is initiated when we have a view on the underlying in addition to the volatility expectation about the market. Volatility judgement plays a key role in the success of this strategy.
The Put Ratio Back Spread is a 3 leg option strategy. It involves
- Buying 2 OUT OF-THE-MONEY (OTM) Put option
- Selling 1 IN-THE-MONEY (ITM)/ AT-THE-MONEY (ATM) Put option.
Note: All the options should be of the same underlying and same expiry.
2:1 ratio is the classic ratio followed, however we can use multiples of the same. It means 2 options bought for every one option sold, or 4 options bought for every 2 options sold, so on.
This strategy should be devised when the trader is:
- Very Bearish on the underlying asset.
- Volatility is expected to increase to a great extent.
When we implement the Put Ratio Back Spread we have:
- Unlimited profit if the market goes down
- Limited profit if market goes up
- A predefined loss if the market stays within a range
We make money as long as the market moves in either direction, of course the strategy is more favourable if the market goes down.
Nifty Spot is at 16506 and you expect Nifty to hit 16000 by the end of expiry. This is clearly a bearish expectation.
To implement the Put Ratio Back Spread:
- Sell 1 lot of 16500 PE (IN-THE-MONEY (ITM)) @134
- Buy 2 lots of 16200 PE (OUT OF-THE-MONEY (OTM)) @ 46
- Net Cash flow is = Premium Received – Premium Paid i.e. 134 – 92 = 42
Let us check what would happen to the overall cash flow of the strategies at different levels of expiry.
Important pointers of the strategy which we can see here are:
- Spread = Higher Strike – lower strike
16500 – 16200 = 300
- Max loss = Spread – Net Premium Inflow
300 – 42 = 258
- Max Loss occurs at = Lower strike price
- Lower Breakeven point = Lower strike – Max loss 16200 – 258 = 15942
- Upper breakeven point = Lower strike + Max loss
16200 + 258 = 16458
Volatility increase in the underlying is good for this strategy. When you are extremely bearish in an underlying or any news upcoming, then this strategy will give good returns.