A bear put backspread is similar to a long put option as far as your outlook on the underlying stock (i.e. that you want it to go lower), but you use the sale and purchase of different ratios of options to protect against a possible move higher. These are often referred to as “ratio spreads” because you are buying and selling options at intervals of 1:2 or 2:3 etc. With this particular strategy, you would sell a put option and then buy 2 lower strike puts, which still makes you a net buyer of options at a ratio of 1:2.
This is the video tutorial for one of the more complex bearish strategies out there and that’s the bear put backspread. That’s a lot to go through, but we’re going to get right into it here and you guys are going to know everything there is to know about bear put back spreads by the end of this video.
Let’s talk about the market outlook for this particular strategy. You want to enter this strategy if one or two things is going to happen.
Either you’re A: Looking for a sharp move lower in the underlying stock (and you can visually see this on our profit loss diagram because we make a huge profit if the stock moves considerably lower) or you're looking for a sharp move higher in implied volatility during the life of the options.
You can actually bend and mold this strategy, so that it actually does make a credit here on the topside and you actually have a market neutral strategy, but I’ll talk to you more about that at the end of the video.
How to set this up? It’s a little bit more complex than your average run-on-the-mill buying a call or selling a call. It involves selling a number of puts and then buying an even more number of put options of the same underlying stock at a lower strike price.
Let's go over this here. Typically, what’s going to happen is that you’re going to sell one in the money put option, then you’re going to go ahead and buy two out of the money puts and always try to keep that ratio at 1:2.
You can even do a 2:4 or a 10:20, but as long as your ratio is about 1:2, you’re going to be doing a good job on this bear put backspread. This one short put is going to be your 50 strike put on this chart and the two long puts that you’re going to buy are two puts at 45.
Think about it like a put credit spread where you’re actually just buying an extra put option. That’s basically all it is. What's the risk? At expiration, the maximum loss would occur should the stock close directly at the lower strike.
If this happens, then your two long puts that you bought at 45 are going to expire worthless and the short put is going to be in the money by about $500.
That's going to be your maximum paying point, is right here at the long strike price of those long puts. We don't want the market to close there. It can really rally anywhere around here, so the more volatility, the better.
The profit potential on this is theoretically unlimited to the downside. Obviously, we want the market to move considerably lower and go beyond our 40 strike price. And it’s really unlimited beyond there.
Like I had mentioned, you can adjust and mold this strategy, so that you take in a small credit right at the onset, in which case, you’d also have a potential profit on the topside if the stock does rally.
With regard to volatility like I had just mentioned, increases in Vega or volatility are going to have a very positive impact on this strategy. Remember that our overall strategy is that we are long two puts and short only one put.
We’re actually long an extra put all things being equal. The two other options cancel themselves out and we have this extra long put option that’s just remaining in the portfolio.
As we know with long options, volatility tends to be really good for long options, we want increases in volatility, the more volatile the stock, the better as far as the pricing goes for our options.
Time decay is actually going to have a negative impact on this strategy. Since we’re long net extra puts where we have that extra long put right here at 45, then this is going to hurt our overall position.
Every day that the stock doesn't move into an area that creates a profit is actually a day that the strategy decays in value more and more. Breakeven points on this is a little bit hard to calculate, but we’re going to go over it right here right now.
The strategy has two breakeven points because the profit loss line crosses the zero barrier twice, so you can see that it's a fairly market neutral strategy. The upper point is just going to be the strike price of the short put, so in this case, it’s going to be $50. That’s going to be our upper breakeven point.
We actually don’t make any money beyond that in this example, but you can create the strategy to make money on that upper end. The lower point is going to be the strike price of the long put minus the cost of the overall strategy at max loss.
In this case, it's going to be the strike price of the long put which is 45 minus what our maximum loss would be and that's 500 and you can see that our breakeven point is 40. 45 minus 500 or $5 per option contract, that gives us a breakeven point of 40, so the stock has to move considerably below 40 for us to start to make money on the strategy at expiration.
Let’s look at an example. The stock price in this example is going to be $48. We’re going to sell one 50 strike put for $400 and we're going to take that money that we got and we’re going to go right back out into the marketplace and buy two 45 strike puts for $200 each.
You can see here that there's no credit or debit on this trade. It’s basically a free trade. Obviously, you have to include commissions, but for the purposes of this example, the trade doesn’t cost you any money and it doesn't take in any money in our example.
The one put that we sold at 50 is going to completely fund the purchase of the two puts at 45 since they’re $200 apiece. The maximum loss is $500 and this is because we’re going to take the strike price of the short put and it’s going to be subtracting what credit we’re actually going to get if it closes right here at 45.
Remember, if the market closes right at 45 which is our long put, our two puts that we’re long at 45 expire worthless, they’re not worth anything, but our short put at 50 is actually going to be in the money by about $500, so we’re going to have to buy that put back at $500.
That’s what creates the maximum loss. The profit potential is unlimited to the downside. The way that you actually create a possible profit on the topside is that you make sure when you are selling and buying your options here that it actually takes in a small credit.
That's how you adjust this strategy to actually make money on the topside if the market does rally. You don’t want to make a lot of money. You don’t want to lose any money.
For example: You could sell this one put for $450 and buy two 45 puts for $200 each. That would leave you with a $50 credit should the market rally past the 50 strike.
Some tips and tricks with regard to this bear put backspread: This strategy is basically a combination of a bull put spread and a long extra put.
Like I had said in the beginning, think about it like a bull put spread that you take in and you're just adding this extra position here, this extra contract. High volatility stocks are where you want to get into the trade.
That's where the money is the best. You don't want to get into this trade in a market where it’s flat to no volatility. You're going to lose money on this. This needs to be in a high volatility market where stocks are moving.
Again, like we had talked about, it is possible to structure the strategy to make money if the stock rises, just make sure that you sell the short put for more than you purchase the two long puts.
Very easy and it creates a more market neutral strategy overall. As always, I hope you guys really enjoy this video. And if you like the video, please take a second to share this video with any of your friends, family or colleagues on your favorite social network.