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Put Backspread - An option Trading Strategy

A Put backspread option strategy is a multi-legged bearish strategy in which the risk is defined, and the profit potential is unlimited. The strategy can be very beneficial when there is a significant downward movement in the underlying asset price.

Put Backspread is a strategy that includes different components. The investors here sell one short put option in-the-money right above the current stock price and purchase two out-of-the-money long put options at a low price. The strike price of the long puts will be the same. So here, all the three put options will have the same expiration. Traders can enter this strategy for a debit or a credit, depending upon the price of the contracts. Generally, the majority of Put backspreads are open for credit. The strategy waits for the price to move downwards and make a profit. Suppose the put backspread is open for credit; the position can profit if the price rises.

Put backspread from the market's perspective:

A trader enters the put backspread when they feel bearish and strongly believe that the underlying asset price will fall below the long strike price at the time of expiry. Traders can make an unlimited profit if the stock closes below the long puts. Suppose there is a very slight fall in the price, then that would not be a good scenario for the trader. When the price increases significantly, then there is a limited risk. If the trader has opened the position for the credit, they may earn a profit with the price increase.

How can I set up a Put backspread?

To set a Put Backspread, traders will require one short put option in-the-money (STO or Selling-To-open) and two long put options out-of-the-money, which must be below the short put options price. While making the ratio of the contracts, make sure you have bought more long puts than the short options sold.

Let us understand with an example: for every short put option, traders need to buy two long put options. If the stock price closes at the strike price of the long put option, then the trader may realize the maximum profit because the short put option will be in-the-money, and the long put will expire worthlessly. Traders get unlimited profit beyond the long put.

The amount received or paid at the entry will be based on how far in-the-money the short put is and how far out-of-the-money the long put options are in relation to the stock price.

Understanding the diagram of Put backspread?

The diagram of the put spread, which is opened for credit, looks like -a V shape. The right side of the V has capped the credit amount received. Risk is predefined while entering into the strategy; if the stock falls, there is a huge profit potential. Traders experience the highest loss if the stock closes exactly the long put's strike price at the time of expiry. If that happens, the short put options will expire in-the-money, and the long put will be left with no intrinsic value.

If the stock closes above the short put at the time of expiry, then all options will expire

worthlessly, and the only credit received while entering will be counted as profit. Suppose the stock price closes below the long puts, then all the options contracts will expire in-the-money, and the trader must close them to avoid their execution. Here traders can still have some intrinsic value left. The spread width between the bull put spread plus or minus (+/-) the cost of entering will be the total profit.

For example: the stock is currently trading at Rs. 52, and the trader believes it will close at Rs. 50 at the time of expiry. In this case, a trader can enter the put backspread by

sell-to-open (STO) one put options at Rs.55 and sell-to-open (STO) two put options at Rs.50. Suppose Rs. 55 options gain Rs. 5, and the two put options cost the trader Rs. 2 each, then this position will make Rs. 1 credit upon entering. Now, if the stock closes at or above Rs. 55, all the options will expire worthlessly, and only Rs. 100 received initially would be profit. Suppose the stock closes at Rs.50, then the long put of Rs. 50 will expire worthlessly, and the short puts will require Rs. 5 to close the position. Thus Rs. 5 credit received minus the Rs. 1 initial credit received will give the amount of maximum loss on this position Rs. -400.

Suppose, the stock closes below Rs.50, then the trader may realize the profit or loss as below calculation. The difference between the stock price and long put options price multiplied by the number of long put contracts add the initial credit gain and deducts the remaining intrinsic value of in-the-money short put options.

Example: if the stock closed at Rs. 48 (below 50), then there will be a net loss of Rs. -200 to the trader; understand how. The short put will be in-the-money at expiry by Rs. 7, and the two long put options will also be in-the-money Rs. 2. The long put opinions will make a profit of Rs. 400 (Rs.2 ITM X 2 contracts), adding the initial credit of Rs. 100 will make this amount Rs 500. But on the other hand, traders also need to close the short put option that will cost them Rs. 700. So the trader got the Rs. 500 but has to pay Rs. 700, incurring a net loss of Rs. -200.

For Put Backspread, there are two break-even prices as suggested below,

1) Short Put’s strike price minus the credit received, and

2) Short Put’s strike price minus the 2x difference between the strike price plus the initial credit.

Considering the above example, the break-even points will be Rs. 46 and Rs.54. If the

stock is below the lower break-even point, traders can receive unlimited profit until

the stock reaches Rs.0.

put backspread trading strategy

How can I enter the put backspread?

A put backspread can be said as the bull put credit spread having one additional put bought at the same strike price as the long put. All the options will have the same expiry date.

To enter into the strategy, traders have to sell-to-open (STO) a short put option, and buy-to-open (BTO) long put options. Make sure the ratio between them is greater than 1:1. Though the bull put spread strategy is bearish, it has an almost similar diagram to that of the single put, having the additional chance to profit on the upside if sold for the credit. The bull put spread helps in reducing the cost of extra long put options and decreases the risk on the position by bringing in the additional credit.

Traders can buy the put backspread for either a debit or for credit. The price of the options will be based on the total spread width, how far-in-the-money short-put options contracts are, and how far out-of-the-money long-put options contracts are in relation to the stock price.

How can I exit from the put backspread?

A Put Backspread will require a noticeable movement below the long put strike prices to get the maximum potential profit. If the stock price is below the long put option contract, then all three options will be in-the-money, and the trader must exit the position to avoid their execution. If the stock price is below the short put while expiry, the contracts will be in-the-money, and traders need to close them to avoid their assignment.

The total profit or loss to the trader will be based on the option's pricing while entering

the strategy. If the stock price is above the short put contract, then all the contracts will expire worthlessly, and the trader does not have to take any further actions. The credit received while entering will remain.

Impact of the Time Decay on Put Backspread:

Put Backspreads are a net long position, and because of this, the time decay or theta works against this strategy. With each passing day, the contract loses its value, which may affect the long put options.

Impact of implied volatility on Put backspread:

An increase in the Implied Volatility's value will have a positive impact on Put Backspread. If the implied volatility is higher, then it will lead to higher option premium prices. Generally, when Put Backspread is opened, the implied volatility is lower compared to the time of expiry exit. To be profitable, the strategy has to rely on the value of the long options. The future volatility or vega is hard to determine or predict accurately. But you should know how the volatility will affect the option contracts' pricing.

How can I adjust the put backspread?

The put backspread strategy has a very limited time to make a profit. If the put backspread is sold for credit while entering, the structure caps the risk, and the put backspread is generally not adjusted. The adjustment can be said to be taking early profit and exiting the trade. Traders may roll the position up or down if it is not in the profit zone. As put backspread has a minimum of one short contract, thus execution before expiry can be risky.

Traders must also consider external factors while adjusting or closing the position. In

cases where traders want to extend the trade's duration or avoid the execution of the

trade, they may close the entire position and reopen it for some future date. The new

position can be reopened with the same strike price or with the new strike prices

depending upon the current market price of the underlying stock.

How to roll the put backspread?

The put backspreads need the stock to close at or below a certain price at the time

of expiry. If traders feel the position is not profitable, the entire position can be closed

and reopened again on some future date. More time in expiry will lead to higher

options prices. The rollout will increase the cost and risk of the position. If there is any

change in the price of the stock, and traders want to take advantage of that, they

may also choose to roll the position up or down.

How to hedge the put backspread?

Hedging the put backspread might be unnecessary because, in this strategy, the risk is already defined. It is a bearish strategy and does not require any protection from the upwards movement in the stock, because the bull put spread has defined the upside risk. Any rise in the stock will lead to a profit that is equal to the credit received while entering.

So, this was all about the put backspreads, hope you are clear with all the parameters

explained on this page. If you have any questions, you may directly reach us using the number provided on the screen or via email.

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