Put Ratio Backspread: A Detailed Explanation and Strategy Guide

In this article, we will discuss

• What is the Put Ratio Backspread?
• Put Ratio Backspread: Market Outlook
• Setting Up a Put Ratio Backspread
• Key Price Levels in the Put Ratio Backspread
• An Example of the Put Ratio Backspread
• The Put Ratio Backspread Made Easier with Samco’s Options B.R.O.
• An Example of the Put Ratio Backspread with Options B.R.O.

Options trading is more nuanced than beginners appreciate. At the outset, it may simply appear to be a question of buying options and choosing to exercise the right or let it expire, or selling options and pocketing the premiums. However, as you gain more experience in the options market, you will discover the many multi-legged options trading strategies designed to suit different market conditions. Options B.R.O from Samco Securities can help you find the best strategies for any market view you hold — whether it is volatile, bearish, bullish or neutral.

When your view about the market changes, your trading strategy should also evolve to align with your changing outlook. With Options B.R.O., you will find that zeroing in on the appropriate strategies is easier than ever. For instance, when you expect the market to be bearish on a particular stock, all you need to do is submit the details of the option contract on that stock, its expiry and your bearish market view. The options strategy builder from Samco Securities will suggest the top strategies for this data set.

The put ratio backspread is one such bearish strategy that works well in declining markets. Let us delve into the finer details of this strategy and discover how it works.

What is the Put Ratio Backspread?

The put ratio backspread is an options trading strategy that works best if you are bearish on the underlying asset. Beginners may simply aim to buy put options if the market view is bearish. However, with a put ratio backspread, you can optimise the risk-reward ratio more effectively.

As the name indicates, this strategy uses both short puts and long puts in a predetermined ratio. Depending on how the trade is set up, you can either have limited profit potential and unlimited loss, or unlimited profit potential and limited loss.

Put Ratio Backspread: Market Outlook

Put backspreads work best when you expect the price of the underlying asset to drop at expiry. To set up a put backspread strategy in a defined ratio, you need to buy more puts than you sell. This is because you are ultimately bearish on the market. The ratio of the long puts to the short puts can vary based on your market outlook, trading budget and risk capacity. Typically, the ratios used can be 2:1, 3:1 or even 3:2.

To make the most of this options trading strategy, start by setting a realistic expectation of how much you expect the price of the underlying to drop within the next 1 to 3 months (depending on the expiry chosen). You can then set up the put ratio backspread as required.

Setting Up a Put Ratio Backspread

To set up a put ratio backspread options strategy, begin by determining the ratio of the positions. You can choose any ratio that works for you, as long as you have more long puts than short puts. That said, all the options should expire on the same day.

For instance, let us say you are setting up a put backspread strategy in the ratio 2:1. In this case, you need to execute the following trades:

• Trade 1: Purchase two out-of-the-money put options with strikes lower than the current asset price
• Trade 2: Sell one at-the-money or in-the-money put option with a strike price higher than the long puts’ strikes

Unlike many other options trading strategies that have defined opening credits or debits, this strategy may lead to a net premium receipt or payment. It depends on how the options are priced at the time of setting up the trade. If your priority is to earn immediate premiums, you can structure the trade accordingly. Alternatively, if your priority is to maximise the profits even at the cost of any initial outflow, you can set up the put backspread strategy in that way.

Key Price Levels in the Put Ratio Backspread

An important part of using any multi-legged options trading strategy is to define the key price levels and possibilities at the outset. More specifically, you need to know the maximum profit, maximum loss and break-even price points. For the put backspread strategy, these key price levels are as follows:

• Spread:

The spread is the main price difference in the strategy. In this case, the spread is simply the difference between the short put’s strike and the long put’s strike.

• Maximum Profit:

The maximum profit in this strategy can be unlimited if the market falls as expected.

• Maximum Loss:

The maximum loss you may incur on the put ratio backspread strategy is the difference between the spread and the net premium received (if any).

• Break-Even Prices:

Depending on how this strategy is set up, you can have two break-even prices. Check out the formulas for these break-even prices:

Lower Break-Even Price = Higher Strike Price — 2x Spread + Net Premium Credit (or Debit)

Higher Break-Even Price = Higher Strike Price — Net Premium Credit

By knowing these key price points, you can decide how to formulate the put ratio backspread strategy effectively.

An Example of the Put Ratio Backspread

Let us discuss an example of how this strategy can be executed. Consider a company’s stock, currently trading at Rs. 683. You expect that this share’s price will fall by expiry and implement the put ratio backspread using the following trades:

• Trade 1: Purchase two out-of-the-money put options, each with a strike price of Rs. 660, and pay a premium of Rs. 6 for each.
• Trade 2: Sell one at-the-money or in-the-money put option with a strike price of Rs. 685 and receive a premium of Rs. 15.

This way, you open the trade at a net credit of Rs. 3 per share in the lot (i.e. Rs. 15 received minus Rs. 12 paid in total). If the lot size is 100 shares, you have a net credit of Rs. 300 at the outset.

Let us calculate the break-even points for this trade using the formulas shown above.

Lower Break-Even Price:

= Higher Strike Price — 2x Spread + Net Premium Credit (or Debit)

= Rs. 685 — (2 x Rs. 25) + Rs. 3

= Rs. 685 — Rs. 50 + Rs. 3

= Rs. 638

Higher Break-Even Price:

= Higher Strike Price — Net Premium Credit

= Rs. 685 — Rs. 3

= Rs. 682

This means that if the price is above Rs. 682 or below Rs. 638, you will incur profits on the trade. However, between these two break-even prices, the put ratio backspread strategy will lead to losses, with the risk maximising at the lower strike price of Rs. 660.

The Put Ratio Backspread Made Easier with Samco’s Options B.R.O.

Hypothetical scenarios are one thing. However, in real-time markets, computing the break-even points and deciding when to initiate the trade can be extremely challenging. By the time you compute the key price level, the markets would have moved — leading to changes in the premium and the profitable price points. This means you will have to revisit your calculations, by which time, the market may change once more.

Options B.R.O from Samco Securities helps you break free of this vicious cycle. You simply need to enter the details of the stock whose options you wish to trade, the expiry of the contract and your market view along with the target price.

Options B.R.O then suggests the three best strategies for your market view. Each strategy suggested has a different risk profile, namely, aggressive, moderate or conservative. You can either go with any of the top 3 options trading strategies suggested, or you could search through hundreds of other suitable strategies to decide which works best for you.

An Example of the Put Ratio Backspread with Options B.R.O.

Say you are bearish on Zydus Lifesciences and expect that the stock will decline further by its near-month expiry. So, you enter the following parameters in Options B.R.O:

• Scrip name (ZYDUSLIFE)
• Expiry date
• Your view on ZYDUSLIFE and your target price for this stock at expiry

Submit these details, and Options B.R.O. will recommend the three best strategies that align with your view. If you do not find the put ratio backspread strategy among the top three options, that’s no cause for concern. You can view hundreds of other strategies in the app. Among these, you can find the put ratio backspread and view the main legs of this strategy.

Let us decode the key aspects of the strategy as seen on Options B.R.O in the Samco trading app.

• Strategy Legs

As you can see from the image below, the strategy has two long puts and one short put. The trades include the following:

• Trade 1: Purchase two out-of-the-money put options, each with a strike price of Rs. 1,140, and pay a premium of Rs. 12.60 for each.
• Trade 2: Sell one at-the-money or in-the-money put option with a strike price of Rs. 1,200 and receive a premium of Rs. 38.50.

• Net Premium

The strategy has a net premium credit since the total cost of purchasing the two puts is less than the income from selling the third put. Let us see how much you can earn from this strategy at the outset.

Net Premium Received:

= Rs. 38.50 — (2 x Rs. 12.60)

= Rs. 13.30 per share (or Rs. 11,970 for a lot of 900 shares)

• Lower and Higher Break-Even Price Points

You can further analyse the strategy with Samco’s Options B.R.O. to check how profit and loss vary at different asset prices. The payoff chart shows you that if the price closes between the two break-even points, you incur a loss. However, if the price closes below the lower break-even point or above the higher break-even price, you earn profits.

Let us compute the two break-even points for this trade:

Lower Break-Even Price:

= Higher Strike Price — 2x Spread + Net Premium Credit (or Debit)

= Rs. 1,200 — (2 x Rs. 60) + Rs. 13.30

= Rs. 1,200 — Rs. 120 + Rs. 13.30

= Rs. 1093 (rounded down)

Higher Break-Even Price:

= Higher Strike Price — Net Premium Credit

= Rs. 1,200 — Rs. 13.30

= Rs. 1,187 (rounded up)

Note that the profit is capped if the price rises, but grows substantially if the price falls below the lower break-even point. This is because the put ratio backspread is built on the assumption that you will have a volatile and large price decline in the underlying asset.

• Maximum Risk

The trade results in the highest loss if the asset’s price closes at the lower strike price. So, in our example, say the price of Zydus Life is Rs. 1,140 at expiry. The maximum loss in this case can be computed using the formula shown below.

Maximum Loss:

= Spread — Net Premium Credit

= Rs. 1,200 — Rs. 1,140 — Rs. 13.30

= 46.70 per share (or Rs. 42,030 for a lot of 900 shares)

With Options B.R.O on the Samco trading app, you need not perform these calculations manually. Instead, you can simply move the price line to compare the profit and loss at different price levels. Once you have identified the ratio and setup that is suitable for your risk-reward preferences, simply execute the trade directly from the Samco trading app.

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