Put Backspread

[Igor 10]

A trader who implements a put backspread strategy is betting that an asset's value will fall. The technique involves selling more put options than purchased, usually 2:1, of the same underlying asset and with the same expiration. The profit potential is infinite when carrying out a put backspread, and investors control any potential losses by selling puts that satisfy the 2:1 ratio.

 

Moneyness Review for Puts:

 

In-The-Money (ITM) = Strike Price (more than) Market Price

Out-of-The Money (OTM) = Strike Price (less than) Market Price

At-The-Money (ATM) Strike Price (equals) Market Price

 

How to Implement a Put Backspread Strategy

 

 

Disney stock is worth $48 (market price) in June.

1) Trader buys two (2) put options: DISJul45($2.00)

- 200 shares of Disney stock

- Strike Price $45 (OTM), expiring in 30 days

- Premium Cost of $2.00

2) Trader sells one (1) put option: DISJul50($4)

- 100 shares of Disney stock

- Strike Price $50 (ITM), expiring in 30 days

- Premium Cost of $4

3) The trader pays $0 to enter the market. [$400 (paid for puts) - $400 (received from sale)]

 

Result one: Disney stock remains at $45 in July.

a) Both the put options purchased expire worthless. (OTM)

b) The put option sold is ITM. The buyer exercises his or her right to sell the trader 100 shares at $50. The trader pays $5000 to the seller.

c) The trader sells 100 Disney shares in the open market, receiving $4500.

d) The trader loses a total of $500 after subtracting the prices paid for the shares from the share sale. [$500 = $5000 (paid for shares) - $4500 (received for shares)]

 

Result two: Disney stock falls (moderately) to $40 in July.

a) The put option sold is ITM. The buyer exercises his or her right to sell the trader 100 shares at $50. The trader pays $5000 to the seller and receives 100 shares.

b) The trader buys 100 Disney shares in the open market, paying $4000.

c) The two put options purchased are ITM. The trader exercises his or her right to sell the trader 200 shares at $45. The trader sells the 200 shares and receives $9000 from the buyer.

d) The trader loses a total of $0 after adding and subtracting the prices paid for the shares from the exercised puts. [$0 = $5000 (paid for 100 shares) + $4000 (paid for 100 shares) - $9000 (received from puts purchased)]

 

Result three: Disney stock falls (crashes) to $30 in July.

a) The put option sold is ITM. The buyer exercises his or her right to sell the trader 100 shares at $50. The trader pays $5000 to the seller and receives 100 shares.

b) The trader buys 100 Disney shares in the open market, paying $3000.

c) The two put options purchased are ITM. The trader exercises his or her right to sell the trader 200 shares at $45. The trader sells the 200 shares and receives $9000 from the buyer.

d) The trader loses a total of $1000 after adding and subtracting the prices paid for the shares from the exercised puts. [$1000 = $9000 (received from puts purchased) - $5000 (paid for 100 shares) - $3000 (paid for 100 shares)]

 

Result four: Disney rallies to $50 in July.

a) All the put options purchased expire worthless (OTM).

b) The trader loses a total of $0 since there was no cost to enter the market.

 

Advantages and Disadvantages of Implementing a Put Backspread Strategy:

 

Pluses: The upside to this type of strategy is that the investor can make substantial profits with limited loss-risk. An investor's profit potential is infinite when market price crashes, since theoretically any asset can reach a zero value. Investors can also enter the market without paying cash. The put backspread also limits the trader's loss potential to the terms of the put option sold. In large market upswings, all options will expire OTM, resulting in no-loss, since there is no cost to enter the market in a 2:1 backspread.

 

Minuses: The downside in using a put backspread strategy happens when the underlying asset's market price expires at-the money with the sold put. However, loss potential continues to decline any price in between the strike prices of puts sold and purchased

Edited May 27, 2012 by Igor

[KBJ 10]

Result three: Disney stock falls (crashes) to $30 in July.

a) The put option sold is ITM. The buyer exercises his or her right to sell the trader 100 shares at $50. The trader pays $5000 to the seller and receives 100 shares.

b) The trader buys 100 Disney shares in the open market, paying $3000.

c) The two put options purchased are ITM. The trader exercises his or her right to sell the trader 200 shares at $45. The trader sells the 200 shares and receives $9000 from the buyer.

d) The trader loses a total of $1000 after adding and subtracting the prices paid for the shares from the exercised puts. [$1000 = $9000 (received from puts purchased) - $5000 (paid for 100 shares) - $3000 (paid for 100 shares)]

 

Shouldn't this be...

 

"The trader wins a total of $1000 after adding and subtracting the prices paid for the shares from the exercised puts. [$1000 = $9000 (received from puts purchased) - $5000 (paid for 100 shares) - $3000 (paid for 100 shares)]"