Traders tend to view the put ratio backspread as a bear strategy, because it employs puts. However, it is actually a volatility strategy. So entering the position when implied volatility is high and waiting for the inevitable adjustment is a smart approach, regardless of the direction of price movement. The strategy based on volatility and time decay is a “price neutral” approach to options and one that makes a lot of sense.
The position is a spread with limited loss potential, but varying profit potential. The degree of profit relies on the strength and rapidity of price movement. The position uses long and short puts in a ratio, such as 2:1 or 3:2 to maximize returns. In most long/short spreads, you make money if the stock moves but lose if it remains in the middle “loss zone.” A ratio put backspread is different because it creates a net credit, so even if the stock price does not move very much, you keep the credit if all of the puts expire worthless.
The typical position combines buying at-the-money or out-of-the-money puts and, at the same time, selling a smaller number of in-the-money puts. Those in-the-money puts are always at risk of exercise, but you have two advantages. First, assignment can be covered by the long puts; second, time decay and implied volatility work in your favor on the short puts. This points out the importance of entering the position when implied volatility is higher than average.
The short position puts (which are in the money) will yield more premium income than the cost of the higher number of at- of out-of-the-money long positions. The ratio itself should vary depending on your belief in the strength, direction and timing of price movement, and also on the cost for each side. Creating a net credit is always desirable, so this also affects how many short and long puts you open.
Another issue is determining which strikes you should use in this strategy. The broader the strike difference between short and long puts, the fewer puts you need to sell to cover the price of the long puts. But at the same time, the coverage of long-to-short is going to be more difficult in the event of assignment. Thus, a 2.5-point difference may be more practical than a 5-point difference in strike prices. With these narrow strike differences, the profit potential is greater, so that the ratio needed is also lower to profit on stock movement.
The most likely candidates for put ratio backspreads are stocks with 2.5-point increments or, better yet, one-point strikes. You are going to set up the spread around the current price level and expect some price movement to create maximum profits. However, with closer increments in the strikes, potential profits will develop more quickly.
The position is a complicated one, even for experienced options traders. Thus, it makes sense to experiment with varying levels of strikes and ratios. Paper trade the put ratio backspread to experience how profits or limited losses develop, and how time to expiration affects both implied volatility adjustments and premium levels.
These relatively complex strategies are best understood by talking them through with other traders. The put ratio backspread would be an excellent topic for the members’ forum on ThomsettOptions.com, for example. This version of “trader therapy” can be quite valuable, especially if you are not sure about the risk profit or mechanics of the trade.