Understanding Back Spread with Puts Strategy in Trading

In this article, we will discuss

• What Are Strategy Legs?
• What Will Be The Payoff?
• Who Can Deploy This Strategy?
• When Should This Strategy Be Deployed?
• Understanding Strategy Greeks
• Things to Keep In Mind
• Conclusion

What Are Strategy Legs?

A back spread with puts strategy is a bearish option strategy that involves selling one put option and buying two put options with the same expiration date but different strike prices. The strike price of the put option bought is lower than the strike price of the put option sold. Usually, the trader sells an at-the-money (ATM) put option and buys two out-of-the-money (OTM) put options.

For example, suppose the current market price of Reliance Industries Ltd. (RIL) is ₹2,000 and the trader expects it to fall sharply in the next month. The trader can implement a back spread with puts strategy by selling one 2,000 strike put option for ₹100 and buying two 1,800 strike put options for ₹50 each. The net cash flow of the strategy is ₹0 (100 - 50 x 2).

What Will Be The Payoff?

The payoff of the back spread with puts strategy depends on the price of the underlying stock at expiration. The trader can make an unlimited profit if the stock price falls below a certain level, a limited profit if the stock price rises above a certain level, or a predefined loss if the stock price stays within a range.

If the trader has a net debit (paid premium) for the strategy, the breakeven point will be:

Strike price of put option bought - (Difference between strike price of put option sold and put option bought) - Net premium paid

In the above example, the net premium paid is zero, so the breakeven point is:

1,800 - (2,000 - 1,800) - 0 = 1,600

The trader will start making a profit if the stock price falls below 1,600 at expiration.

If the trader has a net credit (received premium) for the strategy, there will be two breakeven points:

The lower breakeven point will be:

Strike price of put option bought - (Difference between strike price of put option sold and put option bought) + Net premium received

The upper breakeven point will be:

Strike price of put option sold - Net premium received

For example, suppose the trader sells one 2,000 strike put option for ₹120 and buys two 1,800 strike put options for ₹40 each. The net premium received is ₹40 (120 - 40 x 2).

The lower breakeven point is:

1,800 - (2,000 - 1,800) + 40 = 1,640

The upper breakeven point is:

2,000 - 40 = 1,960

The trader will make a profit if the stock price falls below 1,640 or rises above 1,960 at expiration. Profits exceeding 1960 will cap at 40, while profits below 1640 have the potential to be unlimited.

The trader will incur a loss if the stock price stays between 1,640 and 1,960 at expiration. The maximum loss is equal to the difference between the strike prices minus the net premium received, which is ₹160 in this case.

Who Can Deploy This Strategy?

This strategy can be deployed by experienced traders who have a moderate risk appetite and a strong bearish view on the underlying stock. This strategy can offer high rewards with moderate risk, as the trader can benefit from a large downward movement in the stock price. However, the trader also needs to be confident that there is very little upside risk, as the strategy can result in a loss if the stock price stays within a range or rises moderately.

When Should This Strategy Be Deployed?

This strategy should be deployed when the trader expects a significant decline in the stock price in the near future, due to factors such as negative earnings, poor outlook, market crash, or any other bearish catalyst. A back spread with puts strategy is an ideal strategy in a highly bearish environment, as the stock price usually falls at a faster pace and this strategy can complement the risk-reward ratio positively.

Understanding Strategy Greeks

The strategy greeks of the back spread with puts strategy are as follows:

• Delta: The delta of the strategy is negative, as the strategy profits from a fall in the stock price. The delta becomes more negative as the stock price falls, and less negative as the stock price rises.
• Gamma: The gamma of the strategy is positive, as the delta becomes more sensitive to the changes in the stock price. The gamma is higher for the ATM options and lower at  than the ATM option and ITM/OTM options.
• Theta: The theta of the strategy is negative, as the strategy loses value due to time decay. The theta is dependent on the strike prices selected. If the trader wants to reduce the theta risk, they should select both strikes in such a way that the theta of the short put strike will neutralise twice the theta of the long put strike.
• Vega: The vega of the strategy is positive, as the strategy gains value from an increase in volatility. The vega is higher for the ATM options and lower for ITM/OTM options.

Things To Keep In Mind

This strategy can be a good alternative to a long put strategy, which is also deployed when the trader is aggressively bearish on the underlying stock. However, a long put strategy carries a lot of risk in terms of option greeks, such as theta and vega. A back spread with puts strategy, with its unique strike selection, reduces the risk arising from option greeks at the cost of shifting the breakeven point to a slightly lower level. While executing this strategy, the trader should execute the buy orders first and then execute the sell orders to get the most out of the margin benefit. The trader should also monitor the stock price movement and the option prices closely, and adjust the strategy accordingly if the market conditions change.

Conclusion

Samco Options B.R.O. is a feature in the Samco trading app that helps you select the best options trading strategy based on your market view, risk appetite, and return expectations. It also provides you with the optimal strike prices, expiry dates, and quantities for your chosen strategy.

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