Put Backspread (also called Ratio Volatility Put Spread)

Introduction

You have been researching a stock and have formed a bearish opinion on its value, forecasting both a decline in price and high volatility over a given time period. You would also like to limit your risk if your forecast is incorrect and the stock trades within a narrow range instead.

Building on your foundational knowledge of put options as well as the risks and benefits of single-leg options trades (buy call, sell call, buy put, sell put), you recognize that a spread trade achieves some of the objectives you have outlined.

Taking this a step further, by adding an additional leg you can increase your exposure to potential downside gains.

Recall that the combination of a long put and a short put is referred to as a spread trade. When the ratio deviates from 1:1, the strategy is referred to as a ratio spread. The ratio can vary depending on the implied volatility of the option strikes and may include combinations such as 1:2, 2:3, or 1:5. The overall risks and benefits of each individual option component, or leg, offset one another to a degree in order to create the desired position and range of possible outcomes.

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What is a 1x2 Ratio Volatility Put Spread?

A 1x2 ratio volatility put spread consists of two long puts with a lower strike price and one short put with a higher strike price:

• Long 2 XYZ January 95 puts
• Short 1 XYZ January 100 put

This strategy can be established for either a net credit or for a net debit, depending on the time to expiration, the percentage distance between the strike prices, and the level of volatility.

Profit potential is substantial while risk is limited, although the maximum risk is higher than the initial cost to establish the position. The maximum profit is realized if the stock price falls sharply below the strike price of the long puts.

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Additional Considerations

A 1x2 ratio volatility put spread is equivalent to combining a bull put spread and a long put (with the same strike price as the long put in the bull put spread).

The net premium received from the bull put spread is used to (at least partially) pay for the long put. The position profits if the underlying stock falls sharply below the strike price of the long puts.

The advantage of this strategy is that an out-of-the-money put is purchased for a “low” cost, or possibly a net credit. The disadvantages include:

(1) Risk that is greater than the initial net cost, and

(2) A breakeven point that is further from the current stock price than an at-the-money long put.

A 1x2 ratio volatility put spread is very sensitive to changing volatility. A “small” decline in stock price accompanied by falling volatility might result in a loss, whereas an at-the-money long put might profit. It is therefore important to believe that volatility is low when establishing this strategy.

Worth noting: The term “volatility” in the strategy name implies that more options are purchased than sold. In contrast, a ratio “vertical” spread is a strategy in which more options are sold than purchased. The 1x2 ratio volatility put spread is also referred to as a “backspread” because it is generally used with longer-term, or “back-month,” options as opposed to shorter-term, or “front-month,” options. Longer-term options are more suitable for this strategy because this strategy profits mostly from stock price movement and is hurt by time decay. Longer-term options not only decay at a slower rate than shorter-term options, but they also afford more time for the predicted stock price move to occur.

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Example

• Long 2 XYZ January 95 puts for $1.50
• Short 1 XYZ January 100 put at $3.50

In our example, assume stock XYZ is currently trading at $100.

We buy 2 XYZ January 95 puts for a total of $300 (2 x 100 multiplier x $1.50) and sell 1 XYZ January 100 put for a total of $350 (1 x 100 multiplier x $3.50).

In this example the 1x2 ratio volatility put spread (1 short put + 2 long puts) positions were established for a net credit of $50 ($350 - $300 = $50).

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Outcome 1: Profit

With a 1x2 ratio volatility put spread position, potential profit is substantial to the downside and limited above the short put strike to the upside.

On the upside, potential profit depends on whether the position is established for a net credit or net debit.

• If established for a net credit including commissions, then

Profit = Net Premium Received

If the stock price is above the higher strike price at expiration, then all options expire worthless and the net credit is kept as a profit.

• If established for net debit including commissions, then there is no profit on the upside; a loss equal to the net debit is incurred if all options expire worthless.

First, let’s recall the formulas for individual options positions:

Put Options:

If K – S > 0,

Long Put Profit = Strike Price - Current Stock Price - Net Premium Paid

Short Put Loss = -(Strike Price - Current Stock Price - Net Premium Received)

If K– S < 0,

Short Put Profit = Net Premium Received

Long Put Loss = Net Premium Paid

To calculate our profit on the position we established, we use the formula:

Profit = Profit/Loss on Long Puts + Profit/Loss on Short Put

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Example

Stock XYZ is trading at $100 and you establish a 1x2 ratio volatility put spread for a $0.50 credit.

• Long 2 XYZ January 95 puts for $1.50
• Short 1 XYZ January 100 put at $3.50

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Outcome 2: Loss

Let’s assume we are incorrect in our sentiment, and the stock price trades down slightly. To calculate our loss on the position, use the following formula:

Loss = Profit/Loss on Long Puts + Profit/Loss on Short Put

Risk is limited and the maximum loss is realized if the stock price is at the strike price of the long puts at expiration.

At the strike price of the long puts at expiration, the bull put spread is at its maximum value (and maximum loss) and the long puts expire worthless.

§ If the position is established for a net credit (amount received),

Maximum loss = difference between the strike prices − the net credit

In the example above, the maximum risk is 4.50, because the difference between the strike prices is 5.00 (100.00 – 95.00) and the net credit is 0.50. Therefore, 5.00 −0.50 = 4.50.

§ If the position is established for a net debit (cost),

Maximum loss = difference between the strike prices + the net debit

Instead, if the position had been established for net debit of 50 cents (0.50), the maximum risk would be 5.50, because the difference between the strike prices is 5.00 (100.00 –95.00) so that the maximum loss is 5.00 + 0.50 = 5.50.

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Example

See Profit/(Loss) table above.

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Outcome 3: Breakeven

If the position is established for a net credit, there are two breakeven points:

• Lower breakeven point: Lower strike price – the maximum loss
• Higher breakeven point: Higher strike price – the net credit

If the position is established for a net debit, there is one breakeven point:

• Breakeven point: Lower strike price – the maximum loss

Note: If this position is established for a net debit, there is no “higher breakeven point.” If the stock price is above the higher strike price at expiration, then all options expire worthless, and the net debit plus commissions is lost.

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Example

Long 2 XYZ January 95 puts for $1.50

Short 1 XYZ January 100 put at $3.50

Lower Breakeven Price = $95 - $4.50 = $90.50

Higher Breakeven Price = $100 - $0.50 = $99.50

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At-A-Glance

Strategy

1x2 ratio volatility put spread

Alternative Name

n/a

Pre-Requisite Strategy Knowledge

Long Put

Short Put

Bull Put Spread

Legs of Trade

2 legs

Sentiment

Bearish

Example

· Long 2 XYZ January 95 puts

· Short 1 XYZ January 100 put

Rule to Remember

n/a

Max Potential Profit (GAIN)

On the downside, profit potential is substantial. The position has long puts and the stock price can fall substantially.

On the upside, potential profit depends on whether the position is established for a net credit or net debit.

Break-Even Point

See details above

Max Potential Risk (LOSS)

Risk is limited and the maximum risk is realized if the stock price is at the strike price of the long puts at expiration. At the strike price of the long puts at expiration, the bull put spread is at its maximum value (and maximum loss) and the long puts expire worthless.

Ideal Outcome

XYZ price declines below the long put strike price

Early Assignment Risk

Early assignment risk applies to short options positions only.

Equity options in the United States can be exercised on any business day, and the holder of a short stock options position has no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment must be considered when entering positions involving short options. Early assignment of stock options is generally related to dividends.

The long puts (lower strike) in a 1x2 ratio volatility put spread have no risk of early assignment.

The short put (higher strike) does have such risk.

If assignment is deemed likely, there are two possibilities:

• First, the short put is assigned. In this case, 100 shares of stock are purchased, and the two long puts remain open.
• Second, the put is not assigned.

No matter how likely assignment may seem, there is no assurance that it will occur. In this case the 1x2 ratio volatility spread with puts remains intact.

If early assignment of the short put occurs, stock is purchased, and a long stock position of 100 shares is created. Assignment of the short put does not increase the maximum potential risk, because the long puts that limit position risk remain intact.

If early assignment of the short put does occur and if a long stock position is not wanted, the long stock position can be closed by either exercising one of the long puts and leaving the other put open or by selling 100 shares in the marketplace and leaving both long puts open.

Note, however, that whichever method is used, the date of the stock sale will be one day later than the date of the purchase (by assignment of the short put). This difference will result in additional fees, including interest charges and commissions. Assignment of a short put might also trigger a margin call if there is not sufficient account equity to support the long stock position.

Potential Position Created at Expiration

The position at expiration depends on the relationship of the stock price to the strike prices:

• If the stock price is at or above the strike price of the short put (higher strike), then all options expire worthless and there is no stock position.
• If the stock price is below the higher strike but not below the lower strike, then the short put is assigned, and the long puts expire. Assignment of a short put causes stock to be purchased at the strike price, so the result is a long stock position. Since options are exercised at expiration if they are one cent ($0.01) in the money, if a long stock position is not wanted, then the short put must be closed (purchased) prior to expiration.
• If the stock price is below the lower strike price, then the short put is assigned and both long puts are exercised. In the example above, this means that 100 shares are purchased, and 200 shares are sold. The result is a net short position of 100 shares.
• If the stock price is below the lower strike immediately prior to expiration, and if a short position of 100 shares is not wanted, then one of the long puts must be sold.

Charts

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