Put Backspread Explained

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Contents

Put Ratio Backspread

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Categories: Derivatives

The put ratio backspread is a relatively complicated option strategy that involves simultaneously buying and selling puts. The “ratio” part comes in because you buy more puts than you sell. the ratio of which determines the structure of the trade.

When you sell an options contract, you collect a premium, i.e. you get paid money in the deal. When you buy one, you have to pay out. Those details might sound a little basic, but they’re crucial for explaining the way this setup works.

In setting up the put ratio backspread, you are selling puts in order to pay for other puts you want to buy. Usually, a trader will try to secure a slight gain from the initial buying and selling transactions, so that if all else fails, they will be sure of that small profit. However, trades often get set up with a mild deficit at the start, with the trader hoping to make it up by guessing correctly about the movement of the underlying asset.

Shares of Poot Limited are trading at $20. Puts with a strike price of $21 are trading at $2. Puts with a strike price of $19 are trading at $75. You sell one put with a strike price of $21, bringing yourself $2 in the transaction. Meanwhile, you buy two puts with the $19 strike price, for which you have to pay $0.75 for each. You’ve earned a premium of $2 from the sale, while the puts you bought cost you a total of $1.50. You’re up $0.50 so far. (This is all multiplied by 100, because any option contract applies to 100 shares; your total gain on the deal so far is $50).

Now, if the stock falls below $19, the two puts you bought will pay off. If it doesn’t drop, you’ve still got the small profit you secured from the initial transactions.

Finance: What is the Advance Decline Rat. 14 Views

Finance a la shmoop. What is the advance decline ratio? Alright people it’s just a

percentage just like all its brethren or fellow ratios. Alright but what does that [Guy talking with his arms up]

percentage tell us what’s that ratio all about? Well, basically looks at a given

index like the 500 stocks of the cleverly named S&P 500 or the 30 stocks [List of stocks]

of the Dow or the 1200 ish stocks of the Shmegeggie’s small-cap index, yeah well then [Book of smallcap stocks]

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just adds up which stocks went up that day like well last Tuesday 312 stocks in [Someone using a calculator]

the S&P 500 went up and 185 stocks went down and the rest just sat there not

moving, you know like this guy, a congressman, our finest, best and brightest. So why does this [Someone asleep in the audience]

advance decline number even matter? Like why do we track it, well what if we had

an index where technology stocks comprised like a third of the entire [Pie chart showing the large proportion of tech stocks]

index and you know the saying when Apple catches a cold the rest of tech is [Guy with an Apple briefcase for a head sneezes]

infected with Ebola. Yeah that’s the same really, at least in Silicon Valley. All

right all right maybe you don’t know that saying well it just means that

Apple is a really big market cap stock like knocking on the door of a trillion [Guy talking in front of an Apple store]

bucks, so it represents a huge percentage of the tech index. So when Apple stock

does poorly on a given day it tends to bring down all the other tech stocks in [Apple stock value going down]

its wake, why? Well because so many investors

assume that wherever Apple goes from an investor sentiment perspective that’s [Guy answers the phone is shocked Apple is going down]

where all the other tech stocks will go as well Apple buys a gazillion

semiconductors and storage devices and stamping facilities so if it’s business [Pictures of tech]

softens well then it’s likely that the business of all the others in that tech

ecosystem who feed into it well they soften as well because Apple

is such a big customer in that space. So if Apple and tech dropped 20% in a given

day and all of tech goes down like a meaningful amount and that index is a [Down arrow on the stock index]

third tech well the rest of the market banks, transportation, mining, agriculture [Pictures of the industries]

etc well they might have had just a fine day they might have been up. But if tech

which is a third of that index is all down 20% on that one

day well the overall index would show that well the whole markets down an ugly [Guy showing the market price is down]

six plus percent and all you would have seen as an investor that the blah blah

blah 500 index fell from eight thousand seventy four hundred today, well you [Stock value chart going down]

might think the world was ending when in fact it was only the tech world that [A globe is shot]

ended that day, not everything else like banks might have had a great day, who [Grave stone for tech]

knows all the rest of the stocks that day might have gone up a little bit in

which case two-thirds of the stocks would have advanced and yeah, tech which [Arrow pointing to the other stocks which have increased in value]

was a third of them would have declined and you’d say that the advanced decline

ratio on that day was two to one. So if you were savvy you’d think it really odd

to have an advanced decline ratio at 200% i.e. well above one in a market that

was down a massive six percent that day something would not be adding up in your [Guy in a suit on the phone]

brain and you know to not just trust the index number you actually heard on the

news to reflect what actually happened with market conditions that day right so [Woman on the news showing stock price plummeting]

that’s why you take a very hard look at the advanced decline ratio that’s kind

of a delimiter or truing algorithm in all this.

Chapter 7 Bearish Option Strategies

Bearish Option Strategies

Bearish Option Trading strategy is best used when an options trader expects the underlying assets to fall. It is very important to determine how much the underlying price will move lower and the timeframe in which the rally will occur in order to select the best option strategy. The simplest way to make profit from falling prices using options is to buy put options. Following are the most popular bearish strategies that can be used in different scenarios.

Bearish Options Trading strategies for Falling Markets

Long Put Options Trading

When should you initiate a Long Put Options Trade?

A Long Put strategy is best used when you expect the underlying asset to fall significantly in a relatively short period of time. It would still benefit if you expect the underlying asset to fall gradually. However, one should be aware of the time decay factor, because the time value of put will reduce over a period of time as you reach near expiry.

Why should you use Long Put?

This is a good strategy to use because the downside risk is limited only up to the premium/cost of the put you pay, no matter how much the underlying asset rises. It also gives you the flexibility to select the risk to reward ratio by choosing the strike price of the options contract you buy. In addition, Long Put can also be used as a hedging strategy if you want to protect an asset owned by you from a possible reduction in price.

Strategy Buy/Long Put Option
Market Outlook Extremely Bearish
Breakeven at expiry Strike price – Premium paid
Risk Limited to premium paid
Reward Unlimited
Margin required No

Let’s try to understand with an example:

Current Nifty Price Rs.8200
Strike price Rs.8200
Premium Paid (per share) Rs.60
BEP (Strike Price – Premium paid) Rs.8140
Lot size (in units) 75

Suppose Nifty is trading at Rs.8200. A put option contract with a strike price of Rs 8200 is trading at Rs.60. If you expect that the price of Nifty will fall significantly in the coming weeks, and you paid Rs.4,500 (75*60) to purchase a single put option covering 75 shares.

As per expectation, if Nifty falls to Rs.8100 on options expiration date, then you can sell immediately in the open market for Rs 100 per share. As each option contract covers 75 shares, the total amount you will receive is Rs 7,500 (100*75). Since, you had paid Rs.4,500 (60*75) to purchase the put option, your net profit for the entire trade is therefore Rs.3,000. For the ease of understanding, we did not take into account commission

How to manage risk?

A Long Put is a limited risk and unlimited reward strategy. So carrying overnight position is advisable but one can keep stop loss to restrict losses due to opposite movement in the underlying assets and also time value of money can play spoil sports if underlying assets doesn’t move at all.

Conclusion:

A Long Put is a good strategy to use when you expect the security to fall significantly and quickly. It also limits the downside risk to the premium paid, whereas the potential return is unlimited if Nifty moves lower significantly. It is perfectly suitable for traders who don’t have a huge capital to invest but could potentially make much bigger returns than investing the same amount directly in the underlying security.

Short Call Strategy Explained

Short Call Strategy:

What is Short Call strategy?

A Short Call means selling of a call option where you are obliged to buy the underlying asset at a fixed price in the future. This strategy has limited profit potential if the stock trades below the strike price sold and it is exposed to higher risk if the stock goes up above the strike price sold.

When to initiate a Short Call?

A Short Call is best used when you expect the underlying asset to fall moderately. It would still benefit if the underlying asset remains at the same level, because the time decay factor will always be in your favour as the time value of Call option will reduce over a period of time as you reach near to expiry. This is a good strategy to use because it gives you upfront credit, which will help you to somewhat offset the margin. But by initiating this position you are exposed to potentially unlimited losses if underlying assets goes dramatically high in price.

How to construct a Short Call?

A Short Call can be created by selling 1 ITM/ATM/OTM call of the same underlying asset with the same expiry. Strike price can be customized as per the convenience of the trader.

Strategy Short Call Option
Market Outlook Neutral to Bearish
Motive Earn income from selling premium
Breakeven at expiry Strike price + Premium received
Risk Unlimited
Reward Limited to premium received
Margin required Yes
Probability 66.67%

Let’s try to understand with an Example:

NIFTY Current market Price 9600
Sell ATM Call (Strike Price) 9600
Premium Received 110
BEP (Rs.) 9710
Lot Size 75

Suppose Nifty is trading at Rs.9600. A Call option contract with a strike price of 9600 is trading at Rs.110. If you expect that the price of Nifty will fall marginally in the coming weeks, then you can sell 9600 strike and receive upfront premium of Rs.8,250 (110*75). This transaction will result in net credit because you will receive money in your broking account for writing the Call option. This will be the maximum amount that you will gain if the option expires worthless.

So, as per expectation, if Nifty falls or remains at 9600 by expiration, therefore the option will expire worthless. You will not have any further liability and amount of Rs.8,250 (110*75) will be your profit. The probability of making money is 66.67% as you can profit in two scenarios: 1) when price of underlying asset falls. 2) When price stays at same level.

Loss will only occur in one scenario i.e. when the underlying asset moves above the strike price sold.

Following is the payoff schedule assuming different scenarios of expiry. For the ease of understanding, we did not take into account commission charges and Margin.

On Expiry Nifty closes at Net Payoff from Sell Buy (Rs.)
9300 110
9400 110
9500 110
9600 110
9700 10
9710 0
9800 -90
9900 -190
10000 -290
10100 -390
10200 -490

Payoff Diagram:

Impact of Options Greeks:

Delta: Short Call will have a negative Delta, which indicates any rise in price will have a negative impact on profitability.

Vega: Short Call has a negative Vega. Therefore, one should initiate Short Call when the volatility is high and expects it to decline.

Theta: Short Call will benefit from Theta if it moves steadily and expires at or below strike sold.

Gamma: This strategy will have a short Gamma position, which indicates any significant upside movement, will lead to unlimited loss.

How to manage Risk?

A Short Call is exposed to unlimited risk; it is advisable not to carry overnight positions. Also, one should always strictly adhere to Stop Loss in order to restrict losses.

Analysis:

A Short Call strategy can help in generating regular income in a falling or sideways market but it does carry significant risk and it is not suitable for beginner traders. It’s also not a good strategy to use if you expect underlying assets to fall quickly in a short period of time; instead one should try Long Put strategy.

Put Ratio Spread Explained

What is Put Ratio Spread?

The Put Ratio Spread is a premium neutral strategy that involves buying options at higher strike and selling more options at lower strike of the same underlying stock.

When to initiate the Put Ratio Spread

The Put Ratio Spread is used when an option trader thinks that the underlying asset will fall moderately in the near term only up to the sold strike. This strategy is basically used to reduce the upfront costs of premium and in some cases upfront credit can also be received.

How to construct the Put Ratio Spread?

  • Buy 1 ITM/ATM Put
  • Sell 2 OTM Put

The Put Ratio Spread is implemented by buying one In-the-Money (ITM) or At-the-Money (ATM) put option and simultaneously selling two Out-the-Money (OTM) put options of the same underlying asset with the same expiry. Strike price can be customized as per the convenience of the trader.

Strategy Put Ratio Spread
Market Outlook Moderately bearish with less volatility
Upper Breakeven Long put strike (-/+) Net premium paid or received
Lower Breakeven Short put strike – Difference between Long and Short strikes (-/+) premium received or paid
Risk Unlimited
Reward Limited (when underlying price = strike price of short put)
Margin required Yes

Let’s try to understand with an Example:

NIFTY Current market Price Rs 9300
Buy ATM Put (Strike Price) Rs 9300
Premium Paid (per share) Rs 140
Sell OTM Put (Strike Price) Rs 9200
Premium Received Rs 70
Net Premium Paid/Received Rs 0
Upper BEP 9300
Lower BEP 9100
Lot Size 75

Suppose Nifty is trading at Rs.9300. If Mr. A believes that price will fall to 9200 on expiry, then he can initiate Put Ratio Spread by buying one lot of 9300 put strike price at Rs.140 and simultaneously selling two lot of 9200 put strike price at Rs 70. The net premium paid/received to initiate this trade is zero. Maximum profit from the above example would be Rs.7500 (100*75). It would only occur when the underlying asset expires at 9200. In this case, short put options strike will expire worthless and 9300 strike will have some intrinsic value in it. However, maximum loss would be unlimited if it breaches breakeven point on downside.

For the ease of understanding, we did not take in to account commission charges. Following is the payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry NIFTY closes at Net Payoff from 9300 Put Bought (Rs) Net Payoff from 9200 Put Sold (Rs) (2Lots) Net Payoff (Rs)
8700 460 860 -400
8800 360 660 -300
8900 260 460 -200
9000 160 -260 -100
9100 60 -60 0
9150 10 40 50
9200 -40 140 100
9250 -90 140 50
9300 -140 140 0
9350 -140 140 0
9400 -140 140 0
9450 -140 140 0
9500 -140 140 0

The Payoff Graph:

Impact of Options Greeks:

Delta: If the net premium is received from the Put Ratio Spread, then the Delta would be positive, which means any upside movement will result into marginal profit and any major downside movement will result into huge loss.

If the net premium is paid, then the Delta would be negative, which means any upside movement will result into premium loss, whereas a big downside movement is required to incur huge loss.

Vega: The Put Ratio Spread has a negative Vega. An increase in implied volatility will have a negative impact.

Theta: With the passage of time, Theta will have a positive impact on the strategy because option premium will erode as the expiration dates draws nearer.

Gamma: The Put Ratio Spread has short Gamma position, which means any major downside movement will affect the profitability of the strategy.

How to manage Risk?

The Put Ratio Spread is exposed to unlimited risk if underlying asset breaks lower breakeven hence one should follow strict stop loss to limit losses.

Analysis of Put Ratio Spread:

The Put Ratio Spread is best to use when investor is moderately bearish because investor will make maximum profit only when stock price expires at lower (sold) strike. Although your profits will be none to limited if price rises higher.

Bear Call Option Trading Strategy

What is a Bear Call Spread Option strategy?

A Bear Call Spread is a bearish option strategy. It is also called as a Credit Call Spread because it creates net upfront credit at the time of initiation. It involves two call options with different strike prices but same expiration date. A bear call spread is initiated with anticipation of decline in the underlying assets, similar to bear put spread.

When to initiate a Bear Call Spread Option strategy?

A Bear Call Spread Option strategy is used when the option trader expects that the underlying assets will fall moderately or hold steady in the near term. It consists of two call options – short and buy call. Short call’s main purpose is to generate income, whereas higher buy call is bought to limit the upside risk.

How to construct the Bear Call Spread?

Bear Call Spread can be implemented by selling ATM call option and simultaneously buying OTM call option of the same underlying assets with same expiry. Strike price can be customized as per the convenience of the trader.

Probability of making money

A Bear Call Spread has a higher probability of making money. The probability of making money is 67% because Bear Call Spread will be profitable even if the underlying assets holds steady or falls. While, Bear Put Spread has probability of only 33% because it will be profitable only when the underlying assets fall.

Strategy Sell 1 ATM call and Buy 1 OTM call
Market Outlook Neutral to Bearish
Motive Earn income with limited risk
Breakeven at expiry Strike Price of short Call + Net Premium received
Risk Difference between two strikes – premium received
Reward Limited to premium received
Margin required Yes

Let’s try to understand with an example:

Nifty Current spot price (Rs) 9300
Sell 1 ATM call of strike price (Rs) 9300
Premium received (Rs) 105
Buy 1 OTM call of strike price (Rs) 9400
Premium paid (Rs) 55
Break Even point (BEP) 9350
Lot Size 75
Net Premium Received (Rs) 50

Suppose Nifty is trading at Rs.9300. If Mr. A believes that price will fall below 9300 or holds steady on or before the expiry, so he enters Bear Call Spread by selling 9300 call strike price at Rs.105 and simultaneously buying 9400 call strike price at Rs.55. The net premium received to initiate this trade is Rs.50. Maximum profit from the above example would be Rs.3750 (50*75). It would only occur when the underlying assets expires at or below 9300. In this case both long and short call options expire worthless and you can keep the net upfront credit received. Maximum loss would also be limited if it breaches breakeven point on upside. However, loss would also be limited up to Rs.3750(50*75).

For the ease of understanding, we did not take in to account commission charges. Following is the payoff chart and payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry Nifty closes at Net Payoff from Call Sold 9300 (Rs) Net Payoff from Call Bought 9400 (Rs) Net Payoff (Rs)
8900 105 -55 50
9000 105 -55 50
9100 105 -55 50
9200 105 -55 50
9300 105 -55 50
9350 55 -55 0
9400 5 -55 -50
9500 -95 45 -50
9600 -195 145 -50
9700 -295 245 -50
9800 -395 345 -50

Bear Call Spread’s Payoff Chart:

Impact of Options Greeks:

Delta: The net Delta of Bear Call Spread would be negative, which indicates any upside movement would result in to loss. The ATM strike sold has higher Delta as compared to OTM strike bought.

Vega: Bear Call Spread has a negative Vega. Therefore, one should initiate this strategy when the volatility is high and is expected to fall.

Theta: The net Theta of Bear Call Spread will be positive. Time decay will benefit this strategy.

Gamma: This strategy will have a short Gamma position, so any upside movement in the underline asset will have a negative impact on the strategy.

How to manage Risk?

A Bear Call is exposed to limited risk; hence carrying overnight position is advisable.

Analysis of Bear Call Options strategy:

A Bear Call Spread strategy is limited-risk, limited-reward strategy. This strategy is best to use when an investor has neutral to bearish view on the underlying assets. The key benefit of this strategy is the probability of making money is higher.

What Is A Bear Put Spread Options Trading Strategy?

A Bear Put Spread strategy involves two put options with different strike prices but the same expiration date. Bear Put Spread is also considered as a cheaper alternative to long put because it involves selling of the put option to offset some of the cost of buying puts.

When To Initiate A Bear Put Spread Options Trading?

A Bear Put Spread strategy is used when the option trader thinks that the underlying assets will fall moderately in the near term. This strategy is basically used to reduce the upfront costs of premium, so that less investment of premium is required and it can also reduce the affect of time decay. Even beginners can apply this strategy when they expect security to fall moderately in near the term.

How To Construct The Bear Put Spread?

  • Buy 1 ITM/ATM Put
  • Sell 1 OTM Put

Bear Put Spread is implemented by buying In-the-Money or At-the-Money put option and simultaneously selling Out-The-Money put option of the same underlying security with the same expiry.

Strategy Buy 1 ITM/ATM put and Sell 1 OTM put
Market Outlook Moderately Bearish
Breakeven at expiry Strike price of buy put – Net Premium Paid
Risk Limited to Net premium paid
Reward Limited
Margin required Yes

Let’s try to understand Bear Put Spread Options Trading with an example:

Nifty current market price Rs.8100
Buy ATM Put (Strike Price) Rs.8100
Premium Paid (per share) Rs.60
Sell OTM Put (Strike Price) Rs.7900
Premium Received Rs.20
Net Premium Paid Rs.40
Break Even Point (BEP) Rs.8060
Lot Size (in units) 75

Suppose Nifty is trading at Rs.8100. If you believe that price will fall to Rs.7900 on or before the expiry, then you can buy At-the-Money put option contract with a strike price of Rs.8100, which is trading at Rs.60 and simultaneously sell Out-the-Money put option contract with a strike price of Rs.7900, which is trading at Rs.20. In this case, the contract covers 75 shares. So, you paid Rs.60 per share to purchase single put and simultaneously received Rs.20 by selling Rs.7900 put option. So, the overall net premium paid by you would be Rs 40.

So, as expected, if Nifty falls to Rs.7900 on or before option expiration date, then you can square off your position in the open market for Rs 160 by exiting from both legs of the trade. As each option contract covers 75 shares, the total amount you will receive is Rs 15,000 (200*75). Since, you had paid Rs.3,000 (40*75) to purchase the put option, your net profit for the entire trade is, therefore Rs.12,000 (15000-3000). For the ease of understanding, we did not take in to account commission charges.

Following is the payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry NIFTY closes at Net Payoff from Put Buy (Rs) Net Payoff from Put Sold (Rs) Net Payoff (Rs)
7500 540 -380 160
7600 440 -280 160
7700 340 -180 160
7800 240 -80 160
7900 140 20 160
8000 40 20 60
8100 -60 20 -40
8200 -60 20 -40
8300 -60 20 -40
8400 -60 20 -40
8500 -60 20 -40
8600 -60 20 -40
8700 -60 20 -40

Bear Put Spread’s Payoff Chart:

The overall Delta of the bear put position will be negative, which indicates premiums will go up if the markets go down. The Gamma of the overall position would be positive. It is a long Vega strategy, which means if implied volatility increases; it will have a positive impact on the return, because of the high Vega of At-the-Money options. Theta of the position would be negative.

Analysis of Bear Put Spread strategy:

A Bear Put Spread strategy is best to use when an investor is moderately bearish because he or she will make the maximum profit only when the stock price falls to the lower (sold) strike. Also, your losses are limited if price increases unexpectedly higher.

Put Backspread Explained – Back Spread Options Strategy

What is Put Backspread?

The Put Backspread is reverse of Put Ratio Spread. It is a bearish strategy that involves selling options at higher strikes and buying higher number of options at lower strikes of the same underlying asset. It is unlimited profit and limited risk strategy.

When to initiate the Put Backspread

The Put Backspread is used when an option trader believes that the underlying asset will fall significantly in the near term.

How to construct the Put Backspread?

  • Sell 1 ITM/ATM Put
  • Buy 2 OTM Put

The Put Backspread is implemented by selling one In-the-Money (ITM) or At-the-Money (ATM) put option and buying two Out-the-Money (OTM) put options simultaneously of the same underlying asset with the same expiry. Strike price can be customized as per the convenience of the trader.

Backtracking Algorithms

Backtracking is an algorithmic-technique for solving problems recursively by trying to build a solution incrementally, one piece at a time, removing those solutions that fail to satisfy the constraints of the problem at any point of time (by time, here, is referred to the time elapsed till reaching any level of the search tree).

For example, consider the SudoKo solving Problem, we try filling digits one by one. Whenever we find that current digit cannot lead to a solution, we remove it (backtrack) and try next digit. This is better than naive approach (generating all possible combinations of digits and then trying every combination one by one) as it drops a set of permutations whenever it backtracks.

Recent Articles on Backtracking

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