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Back Spread with Puts

AKA Ratio Volatility Spread; Pay Later Put

NOTE: This graph assumes the strategy was established for a net credit.

The Setup

  • Sell a put, strike price B
  • Buy two puts, strike price A
  • Generally, the stock will be at or around strike price B

NOTE: Both options have the same expiration month.

Who Should Run It

All-Stars only

When to Run It

You’re extremely bearish on a highly volatile stock.

The Sweet Spot

You want the stock to completely tank.



About the Security

Options are contracts which control underlying assets, oftentimes stock. It is possible to buy (own or long) or sell (“write” or short) an option to initiate a position. Options are traded through a broker, like TradeKing, who charges a commission when buying or selling option contracts.

Options: The Basics is a great place to start when learning about options. Before trading options carefully consider your objectives, the risks, transaction costs and fees.

The Strategy

This is an interesting and unusual strategy. Essentially, you’re selling an at-the-money short put spread in order to help pay for the extra out-of-the-money long put at strike A.

Ideally, you want to establish this strategy for a small net credit whenever possible. That way, if you’re dead wrong and the stock makes a bullish move, you can still make a small profit. However, it may be necessary to establish it for a small net debit, depending on market conditions, days to expiration and the distance between strikes B and A.

Ideally, it would be nice to run this strategy using longer-term options to give the stock more time to move. However, the marketplace isn’t stupid. It knows that to be the case. So the further you go out in time, the more likely it is that you will have to establish the strategy for a debit.

In addition, the further the strikes are apart, the easier it will be to establish the strategy for a credit. But as always, there’s a tradeoff. Increasing the distance between strike prices also increases your risk, because the stock will have to make a bigger move to the downside to avoid a loss.

Notice that the Profit + Loss graph at expiration looks quite ugly. If the stock only makes a small move to the downside by expiration, you will suffer your maximum loss. However, this is only the risk profile at expiration.

After the strategy is established, if the stock moves to strike A in the short term, this trade may actually be profitable if implied volatility increases. But if it hangs around there too long, time decay will start to hurt the position. You generally need the stock to continue making a bearish move well past strike A prior to expiration in order for this trade to be profitable.

Maximum Potential Profit

There is a substantial profit potential if the stock goes to zero. But keep in mind stocks don’t go to zero very often. Choose your stock wisely and be realistic.

Maximum Potential Loss

Risk is limited to strike B minus strike A, minus the net credit received or plus the net debit paid.

Break-even at Expiration

If established for a net debit, the break-even point is strike A minus the maximum risk (strike B minus strike A plus the net debit paid).

If established for a net credit, there are two break-even points for this play:

  • Strike A minus the maximum risk (strike B minus strike A minus the net credit received)
  • Strike B minus the net credit received

TradeKing Margin Requirements

Margin requirement is the difference between the strike prices of the short put spread embedded into this strategy.

NOTE: If established for a net credit, the proceeds may be applied to the initial margin requirement.

Keep in mind this requirement is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.

As Time Goes By

The net effect of time decay depends on where the stock is relative to the strike prices and whether or not you’ve established the strategy for a net credit or debit.

If the strategy was established for a net credit:

Time decay is your enemy if the stock is below strike B, because it will erode the value of your two long puts more than the value of the short put. Time decay will do the most damage if the stock is at or around strike A, because that’s where your maximum loss will occur at expiration.

If the stock is at or above strike B, time decay is your friend. You want all of the options to expire worthless so you can capture the small credit received.

If the strategy was established for a net debit:

Time decay is the enemy at stock prices across the board, because it will erode the value of your two long puts more than the value of the short one.

Implied Volatility

After the strategy is established, an increase in implied volatility is almost always good. Although it will increase the value of the option you sold (bad), it will also increase the value of the two options you bought (good). Furthermore, an increase in implied volatility suggests the possibility of a wide price swing.

The exception to this rule is if you established the strategy for a net credit and the stock price is above strike B. In that case, you may want volatility to decrease so the entire spread expires worthless and you get to keep the small credit.

Options Guy's Tips

  • If you own a volatile stock, this is a potential way to protect your investment against a large downturn with a smaller cash outlay than it would take to purchase a put outright for protection.
  • This is a trade you might want to consider just prior to a major news event if you expect the outcome to be negative. Examples include pending FDA rejection of a “miracle drug” on a pharmaceutical stock or a bad outcome from a major legal case. A real-life example of when this strategy might have made sense was in the banking sector during the sub-prime mortgage crisis of 2008.


Tools

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