Put Ratio Back Spread Options Trading Strategy to Profit from a Bearish Market

Background

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.

1. Profits are virtually limitless should the market take a downturn.
2. Limited profit if market goes up
3. A predefined loss if the market stays within a range

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 –

1. Sell one lot of 7500 PE (ITM)
2. Buy two lots of 7200 PE (OTM)

Make sure –

1. The Put options belong to the same expiry
2. Belong to the same underlying
3. The ratio is maintained

The trade set up looks like this –

1. 7500 PE, one lot short, the premium received for this is Rs.134/-
2. 7200 PE, two lots long, the premium paid is Rs.46/- per lot, so Rs.92/- for 2 lots
3. Net Cash flow is = Premium Received – Premium Paid i.e 134 – 92 = 42 (Net Credit)

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 –

• 7200 PE, would expire worthless, since we are long 2 lots of this option at Rs.46 per lot, we would lose the entire premium of Rs.92 paid

• 7500 PE would also expire worthless, but we have written this option and received a premium of Rs.134, which in this case can be retained back

• The net payoff from the strategy is 134 – 92 = 42

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.

• At 7458, the 7500 PE will have an intrinsic value. As you may recall, the put option intrinsic value can be calculated as Max [Strike – Spot, 0] i.e Max [7500 – 7458, 0] hence 42

• Since we have sold 7500 PE at 134, we will lose a portion of the premium received and retain the rest. Hence the payoff would be 134 – 42 = 92

• The 7200 PE will not have any intrinsic value, hence the entire premium paid i.e 92 is lost

• So on one hand we made 92 on the 7500 PE and on the other we would lose 92 on the 7200 PE resulting in no loss, no gain. Thus, 7458 marks as one of the breakeven points.

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.

• At 7200, 7500 PE would have an intrinsic value of 300 (7500 – 7200). Since we have sold this option and received a premium of Rs.134, we would lose the entire premium received and more. The payoff on this would be 134 – 300 = – 166

• 7200 PE would expire worthless as it has no intrinsic value. Hence the entire premium paid of Rs.92 would be lost

• The net strategy payoff would be -166 – 92 = – 258

• This is a point where both the options would turn against us, hence is considered as the point of maximum pain

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 –

• At 6942, 7500 PE will have an intrinsic value equivalent of 7500 – 6942 = 558. Since have sold this option at 134, the payoff would be 134 – 558 = – 424

• The 7200 PE will also have an intrinsic value equivalent of 7200 – 6942 = 258 per lot, since we are long two lots the intrinsic value adds upto 516. We have initially paid a premium of Rs.92 (both lots included), hence this needs to be deducted to arrive at the payoff would be 516 – 92 = +424

• So on one hand we make 424 on the 7200 PE and on the other we would lose 424 on the 7500 PE resulting in no loss, no gain. Thus, 6942 marks as one of the breakeven points.

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.

• At 6800, 7500 PE will have an intrinsic value of 700 and since we are short 7500PE at 134, we would lose 134 -700 = – 566

• 7200 PE will have an intrinsic value of 400. Since we are long 2 lots, the intrinsic value would be 800. Premium paid for two lots is Rs.92, hence after adjusting for the premium paid, we get to make 800 – 92 = +708

• Net strategy payoff would be 708 – 566 = +142

You can analyze the potential return on investment you can make, depending on how far the market goes down before expiry.

We can conclude –

1. If markets go down, then the profits are unlimited
2. There are two breakeven points
3. The point at which maximum loss occurs is at 7200
4. If markets goes up, then the profits are limited