Is the backspread always a bear strategy?

December 28, 2015 09:00 AM

Most traders think of the put ratio backspread as a bear strategy. Why? Because it involves puts. But in fact, it is not a bear strategy, but a volatility strategy. That means it’s designed to turn profitable when the underlying experiences large swings in either direction.

The put ratio backspread is designed to create a net close to zero, meaning very small credit adequate to cover trading costs, and perhaps a little more. The potential loss is limited, but profit potential depends on the direction of price movement. Time decay plays a major role, creating profitable status on the short side while waiting out the price movement on either side.

The put ratio backspread has two elements. First is that it combines short and long puts. Second, the ratio refers to the disparity in the number of long and short positions. Typically, the strategy combines at-the-money or in-the-money long puts with a smaller number of out-of-the-money short puts. While the in-the-money puts are at risk of exercise, there are two offsetting advantages: The exercised puts can be covered with your long puts, so the loss is limited to the distance between the strikes; both time decay and changes in implied volatility will work to reduce premium value, meaning you can close one or more of the shorts at a profit, often very soon after they were opened.

If you buy three long in-the-money puts and sell two in-the-money puts, you set up a 3:2 put ratio backspread. For example, a company has strikes one point apart. Shares were at $39.17. At that moment, the May 38 puts were at 0.82 and the May 40 puts at 1.75. You set up a 3:2 put ratio backspread with the following:

        Buy three May 38 puts @ 82 =    ($246)

        Sell two May 40 puts @ 1.75 =     $350

        Net credit =     $104

The net credit is adequate to cover the net loss in the case of one exercise. However, volatility may create fast changes in implied volatility, so that the short positions can be closed profitably. If the stock price declines and the short puts move in-the-money, these also can be rolled forward. The net exposure is only one contract (3:2 ratio), but the net premium is a 1.04 credit.
You will discover that stocks with one-point strike increments provide the best flexibility. When compared to a 2.5-point or 5-point space, you will see that the exercise exposure is more advantageous in the smaller strike situations.

The backspread option trade can be bullish, bearish or a weighted volatility bet. The reverse-ratio call spread version involves selling one call and buying a higher number of calls at a higher price. In this strategy, you benefit the most if the stock moves up, so it has a bullish bias.

A put spread is generally bearish, and involves selling one put and buying a higher number of puts at a lower price. The greatest benefit is achieved when the stock price falls but also  can earn quick profits with a spike in volatility. 

In both versions, the purpose of the short position is to reduce the overall cost, and the short risk is covered by one of the long options with strikes above (call) or below (put).

It gets complicated, though, when you consider that backspreads can also be set up as calendar or diagonal spreads. In other words, there is a lot of variety possible with the backspread. The most popular is probably the put ratio backspread with net cost close to zero after trading costs. The maximum loss is limited and profit relies on the extent of price movement. The trader normally relies on time decay to make the short position profitable.

About the Author

Michael Thomsett is author of 11 options books and has been trading options for 35 years. He blogs at the CBOE Options Hub and several other sites.