In chapter 4 of this module, the “Call Ratio Back spread” strategy was thoroughly discussed. Similarly, when a trader is bearish on the market or stock, they can employ the Put ratio back spread.
Implementing the Put Ratio Back Spread provides an experience of a broader scope.
In simpler words you make money as long as the market moves in either direction, of course the strategy is more favorable if market goes down.
The Put Ratio Back Spread is typically placed for a ‘net credit’, with funds being added to your account as soon as you enter the position. If the market moves higher than anticipated, you will benefit from the ‘net credit’ and if it falls, you could make an unlimited profit.
I suppose this should also explain why the put ratio back spread is better than buying a plain vanilla put option.
– Strategy Notes
The Put Ratio Back Spread involves two OTM Put options and one ITM option, forming a 2:1 ratio. This classic combo must always remain in this specific proportion when executing the strategy. The ratio can also be extended to 3:2 and so on.
Let take an example – Nifty Spot is at 7506 and you expect Nifty to hit 7000 by the end of expiry. This is clearly a bearish expectation. To implement the Put Ratio Back Spread –
Make sure –
The trade set up looks like this –
With these trades, the Put ratio back spread is executed. Let us check what would happen to the overall cash flow of the strategies at different levels of expiry.
Do note we need to evaluate the strategy payoff at various levels of expiry, as the strategy payoff is quite versatile.
Scenario 1 – Market expires at 7600 (above the ITM option)
At 7600, both the Put options would expire worthless. The intrinsic value of options and the eventual strategy payoff is as below –
Do note, the net payoff of the strategy at 7600 (higher than the ITM strike) is equivalent to the net credit.
Scenario 2 – Market expires at 7500 (at the higher strike i.e the ITM option)
At 7500 both the options would have no intrinsic value, hence they both would expire worthless. Hence the payoff would be similar to the payoff we discussed at 7600. Hence the net strategy payoff would be equal to Rs.42 (net credit).
In fact, as you may have guessed, the payoff of the strategy at any point above 7500 is equal to the net credit.
Scenario 3 – Market expires at 7458 (higher breakeven)
Similarly, to the call ratio back spread strategy, the put ratio back spread has two breakeven points – an upper level and a lower level. 7458 is the upper level which we’ll go into more detail about later on in the chapter.
Scenario 4 – Market expires at 7200 (Point of maximum pain)
This is the point at which the strategy causes maximum pain, let us figure out why.
Scenario 5 – Market expires at 6942 (lower breakeven)
At 6942, both the options would have an intrinsic value; however, this is the lower breakeven point. Let’s figure out how this works –
Scenario 6 – Market expires at 6800 (below the lower strike price)
Remember, the put ratio backspread is a bearish strategy with the goal of making money if the market falls below the lower breakeven point. Let us now look at how the payoff behaves when the market drops beneath this point.
You can analyze the potential return on investment you can make, depending on how far the market goes down before expiry.
We can conclude –