Understanding the "Option Strategy"

Lesson -> The Put Ratio back spread

9.1 - Background

In chapter 4, we discussed extensively the "Call Ratio Back Spread" strategy. The Put ratio back spread works in the same way, except that it is invoked by traders who are bearish on the stock or market.

This is the Put Ratio back Spread's broad scope.

  1. Unlimitable profit in the event of a market decline
  2. Limited profit if market goes up
  3. If the market remains within a certain range, a predetermined loss

Simply put, you make money as long the market moves in any direction. However, a strategy that is less favorable if the market falls will result in more profit.

The Put Ratio Back Spread is usually deployed for a net credit. This means that money flows into your account immediately after you execute the Put Ratio Back Spread. If the market is up, your net credit will be what you make. If the market does indeed fall, you can still make a profit.

This should also help explain why the put spread back spread is more profitable than purchasing a vanilla option.

9.2 - Strategy Notes

The Put Ratio back Spread strategy is a strategy with three legs that includesTwo OTMs purchasedPlace optionsSelling one ITM Put option. This is the classic 2:2 combination. The put ratio back spread should be in the ratio of 2:1. This means that for every option sold, you must buy 2 options. For every 2 options, 3 options must be purchased.

Consider this: Nifty Spot is 7506, and you expect it to reach 7000 before expiry. This is a bearish expectation. The Put Ratio Back Spread can be implemented here

  1. SellOneLot of 7500 PE (ITM).
  2. BuyTwoLots of 7200 PE (OTM).

You should ensure that -

  1. To the same expiry put option also lies.
  2. You belong to the same underlying
  3. This ratio is maintained

This is how the trade setup looks.

  1. 7500 PE, one lot less, the premium for this is Rs.134/.
  2. 7200 PE, two lots, the premium is Rs.46/– per lot, or Rs.92/– for 2 lots
  3. Net Cashflow is = Premium Received + Premium Paid, i.e. 134 - 92).42(Net Credit).

The Put ratio back spread can be executed with these trades. Let's see what happens to the cash flow at different expiry levels.

We need to assess the strategy payoff at different levels of expiry. The strategy payoff can be quite flexible.

Scenario 1: Market expires at 7600 (above ITM option).

Both the Put and Call options would be worthless at 7600. Below is the intrinsic value of options as well as the strategy payoff.

  • 7200 PE would be worthless as we have 2 lots at Rs.46 each.LoseThe entire premium of Rs.92 was paid
  • 7500 PE could also be worthless. However, we have written the option and received Rs.134 as a premium. This can then be retained.
  • The strategy yields a net return of 134 to 92 =42

Note that the net payoff at 7600 is higher than the ITM strike and equals the net credit.

Scenario 2: Market expires at 7500 (at a higher strike, i.e. the ITM option).

Both options would lose their intrinsic value at 7500, so they would be worthless. The payoff would therefore be the same as the 7600 payoff. The net strategy payoff would therefore be Rs.42 (net credits).

As you might have guessed, the net credit is equal to the payoff for any strategy above 7500.

Scenario 3: Market closes at 7458 (higher break-even)

The put ratio back spread strategy has two breakeven points, i.e. the upper and lower breakeven points. The upper breakeven level is 7458. We will talk about how we got to the upper breakeven point later in this chapter.

  • The 7500 PE will have an intrinsic price at 7458. The intrinsic value of a put option can be calculated as Max[Strike-Spot, 0], i.e. Max[7500-7458, 0, 42
  • We will retain 7500 PE and lose some of the premium we received since we sold 7500 PE at the 134 price. The payoff would then be 134 - 42 =92
  • The 7200 PE has no intrinsic value and the premium of 92 will be lost.
  • On the one hand, we made 92 on 7500 PE while on the other hand, we would lose 92 if we used 7200 PE. This results in no loss and no gain. The breakeven point is therefore 7458.

Scenario 4: Market closes at 7200 (Point-of-maximum pain).

This is where the strategy causes the most pain. Let's find out why.

  • 7500 PE would be worth 300 at 7200. 7500 PE would be worth 7200. We would lose all of the premium we received for this option, plus more, since we sold it and received a premium Rs.134. This would result in a payoff of 134 to 300.- 166
  • 7200 PE would be worthless because it has no intrinsic value. The entire premium of Rs.92 would go without effect.
  • The strategy's net payoff would be =-166 + 92- 258
  • This is the point at which both options are against us.This is the maximum pain point.

    Scenario 5: Market expires at 694 (lower break-even)

    Both options would have an intrinsic worth of 6942. However, this is the lower breakeven point. Let's see how it works.

  • 7500 PE at 6942 will have an intrinsic value equivalent to 7500 - 66942 = 558. This option was sold at 134. The payoff would have been 134 - 558 =- 424
  • The 7200 PE will also have an equivalent intrinsic value of 7200 - 76942 = 258 each lot. Since we have two lots, the intrinsic value is up to 516. To arrive at the payoff, 516 - +424 = 92 has to be deducted from the premium we paid initially.
  • On the one hand, we make 424 from the 7200 PE while on the other hand we lose 424 to the 7500 PE. This would result in no loss and no gain. Thus, 6942 marks is one of the breakeven points.
  • Scenario 6: Market expires at 6800 (below lower strike price).

    The put ratio backspread strategy is bearish. The put ratio backspread is supposed to make money if the market falls below the lower breakeven level. Let's now see how the payoff behaves at lower levels than the lower breakeven point.

  • 6800 PE will have an intrinsic worth of 700, and 7500 PE at 134 is short 7500PE, so we would lose 134 =- 566
  • 7200 PE will have an intrinsic worth of 400. The intrinsic value of 800 would result from us being long two lots. After adjusting for premium, the result is 800 - 92 = +708
  • The net strategy payoff would then be 708 - 56 = +142
  • You can also evaluate the strategy payoff at different market expiry levels and you'll see that profits are unlimited as long as market falls. The following table shows the same. (IMAGE1)
    The strategy payoff graph is created by plotting the payoff points.

    The graph explains-

  • Profits are unlimited if markets fall
  • There are two breakeven points
  • 7200 is the point at which maximum loss can occur.
  • If the market goes up, profits are restricted
  • 9.3 - Strategy generalization

    The key strategies levels can be summarized as follows -

  • Spread = Higher Strike – Lower Strike
    1. 7500-7200 = 300
  • Max loss = Spread - Net credit
    1. 300 - 42 = 258
  • Max Loss occurs when the strike price is lower
    Lower breakeven point=
    Lower strike-Max loss
    1. 7200 - 258 = 69442
  • Upper breakeven point = Lower strike and Max loss
    1. 7200 + 258 = 7558
  • 9.4 - Delta and strike selection as well as the effect of volatility

    The strategy becomes more profitable the more the market falls, as we all know. This is also a directional strategy that makes it profitable when the market falls. Therefore, the overall strategy delta should reflect this.let's figure this out with some mathematical calculation-

  • 7500 PE is an ITM option. Delta is 0.55 The delta is -(0.55) = +0.55 since we wrote the option.
  • 7200 PE is OTM and has a delta value of - 0.29. Remember that we have two lots here
  • The total position delta would be +0.55 + (+0.29) + (+0.29) =- 0.03
  • Delta values that are not zero indicate that the strategy is sensitive (but not negligible) to directional movements. If the market falls, the negative sign means that the strategy is profitable.

    I recommend that you use the traditional combination of OTM and ITM options for strikes. The trade must be executed for a net credit. If there is a net cash outflow at the time you execute this strategy, do not initiate it.

    Let's take a look at volatility variation and how it affects the strategy.
    (IMAGE 3).

    Three colored lines represent the difference between "premium value" and volatility. These lines allow us to understand the impact of volatility increase on our strategy while keeping time to expiry in perspective.

  • Blue LineThis line indicates that volatility increases when there is enough time for expiry (30 days), which is good news for the Put ratio back spread. The strategy payoff goes up from -57 and +10 when volatility rises from 15% to 30%. This means that, when there is plenty of time for expiry, you need to be able to see the volatility and also have an accurate view of the stock/index direction. Even though I am bearish on the stock, I wouldn't hesitate to deploy this strategy early in the series if volatility is higher than usual (say, more than twice the normal volatility reading).
  • Green lineThis line indicates that volatility increases when there is approximately 15 days before expiry. However, it is not as beneficial as in the previous case. The strategy payoff goes up from -77 and -47, respectively, when volatility increases by 15% and 30%.
  • Red lineThe premium value does not suffer from volatility increases that occur when there are only a few days left before expiry. This means that you should only worry about the direction of volatility when you get close to expiry.
  • Key points

  • When your outlook on the stock/index bearish, the Put Ratio Back spread works best
  • This strategy will require you to sell 1 ITMPE and buy 2 OTMPE. It is to be done in the same proportion, i.e. for every 1 option, 2 options must be purchased
  • This strategy is often executed to obtain a 'Net credit'
  • This strategy can make a small profit if stock prices rise, but it can also make a large profit if stock prices fall.
  • There are two types of breakeven points: lower breakeven or upper breakeven.
  • Spread = Higher Strike, Lower Strike
  • Net Credit = Premium received for higher strike - 2*Premium for lower strike
  • Spread = Max Loss - Net Credit
  • Max Loss at = Lower Strike
  • When the market goes up, you get net credit.
  • Lower Breakeven = Lower Strike - Max Loss
  • Upper breakeven=
    Lower strike=Max loss
  • No matter when the expiry date is, you can choose between OTM and ITM strikes.
  • This strategy is best when there is more time before expiry.