Put backspreads have three components: one short put option sold in-the-money above the current stock price and two out-of-the-money long put options purchased at a lower price. The long puts will have the same strike price. All three put options have the same expiration date. Put backspreads may be opened for a debit or a credit, depending on the options contacts’ pricing. However, put backspreads are typically established for a credit. The strategy looks to take advantage of a significant move down in the underlying stock and, if the position is opened for a credit, also has profit potential if the security moves higher.
Put Backspread market outlook
A put backspread is purchased when an investor is bearish and believes the underlying asset’s price will be below the long put strike prices at expiration. The profit potential is unlimited below the long puts. A slight decrease in price is the worst scenario for a put backspread. The risk is limited if the underlying stock price increases significantly. If the put backspread is opened for a credit, the position will profit from an increase in price.
How to set up a Put Backspread
A put backspread consists of selling-to-open (STO) one short put option in-the-money and buying-to-open (BTO) two long puts out-of-the-money below the short put option. The number of contracts must have a ratio where more long puts are purchased than short puts are sold.
For example, 1 short put option would require 2 long put options. If the position is opened for a credit, the maximum loss is realized if the underlying stock price is at the strike price of the long put option at expiration, because the short put would be in-the-money and the long puts would expire worthless. The profit potential is unlimited beyond the long put options.
The debit paid or credit collected at entry will depend on how far in-the-money the short put option is and how far out-of-the-money the long put options are relative to the underlying stock price.
Put Backspread payoff diagram
The payoff diagram for a put backspread opened for a credit is V-shaped, with the right side of the “V” capped at the amount of credit received. The risk is defined at entry, while the profit potential is unlimited to the downside. The maximum loss is the credit received at entry, minus the width of the spread. The max loss is realized if the underlying stock closes right at the strike price of the long put options at expiration. In this scenario, the short put would finish in-the-money, and the long puts would have no intrinsic value.
If the stock price closes above the short put at expiration, all options will expire worthless, and the credit received at entry would be realized as a profit. If the stock price closes below the long puts at expiration, all options would expire in-the-money and need to be closed to avoid exercise and assignment. The intrinsic value of the remaining long put option would remain. The width of the spread between the bull put spread, plus or minus the entry pricing, would equal the net profit.
For example, if a stock is trading at $52, and an investor believes the stock will close below $50 at expiration, a put backspread may be entered by selling-to-open (STO) one $55 put option and buying-to-open (BTO) two $50 put options. If the $55 put option received $5.00 in credit, and the two $50 put options cost $2.00 each, the position would create a $1.00 credit at entry. If the stock is at or above $55 at expiration, all of the puts expire worthless and the $100 initial credit received is realized as a profit. If the underlying stock price is $50 at expiration, the long $50 strike puts would expire worthless, and the short put will cost $5.00 to close. The $5.00 to close, minus the $1.00 initial credit, results in the maximum loss for the position of -$400.
If the stock is below $50 at expiration, the realized profit or loss would be the difference between the stock price and the long put price, multiplied by the number of long put contracts, plus the initial credit received, minus the intrinsic value of the in-the-money short put option. For example, if the stock closed at $48 at expiration, the net loss would be -$200. The short put would be in-the-money $7.00 and the two long puts would be in-the-money $2.00. The long puts would profit $400 ($2.00 ITM x2) + the initial credit of $100 = +$500. But, the short put would need to be closed for -$700.
There are two break-even prices for a put backspread: 1) the strike price of the short put minus the credit received and 2) the strike price of the short put minus two times the difference between the strike prices plus the initial credit. In the example above, the two break-even prices are $46 and $54. If the underlying stock is below the lower break-even price, the profit is unlimited to the downside until the stock reaches $0.
Entering a Put Backspread
A put backspread is a bull put credit spread with an additional put purchased at the same strike price as the long put in the spread. All options have the same expiration date.
To enter the position, sell-to-open (STO) a short put option and buy-to-open (BTO) long put options. The ratio of long puts to short puts must be greater than 1:1. Despite the bull put spread, the strategy is bearish. The put backspread has a similar payoff diagram and outlook as a single long put, but with an additional opportunity for profit on the upside when sold for a credit. The bull put spread reduces the price of the additional long put option and decreases the potential risk by bringing in a credit.
Put backspreads may be purchased for a debit or sold for a credit. The price at entry will depend on the width of the spread, how far in-the-money the short put option is, and how far out-of-the-money the long put options are relative to the underlying’s stock price.
Exiting a Put Backspread
A put backspread needs significant movement below the long put strike prices for maximum profit potential. If the underlying stock price is below the long puts at expiration, all three options are in-the-money and must be exited to avoid exercise and assignment. If the stock price is below the short put at expiration, the contract is in-the-money and needs to be closed to avoid assignment.
Profit or loss will depend on the pricing at entry. If the stock price is above the short put option, all contracts will expire worthless, and no action is needed. The credit to enter the position will remain.
Time decay impact on a Put Backspread
Put backspreads are a net long position. Therefore, time decay, or theta, works against the strategy. Every day the time value of an options contract decreases, which will hurt the value of the two long put options.
Implied volatility impact on a Put Backspread
Put backspreads benefit from an increase in the value of implied volatility. Higher implied volatility results in higher option premium prices. Ideally, when a put backspread is opened, implied volatility is lower than where it is at exit or expiration. The strategy relies on the value of the long options to be profitable. Future volatility, or vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the pricing of the options contracts.
Adjusting a Put Backspread
Put backspreads have a finite amount of time to be profitable. If the put backspread is sold for a credit at entry, and the position’s structure limits risk, put backspreads are typically not adjusted. The primary adjustment for a put backspread would be early profit taking to realize a gain. The position may be rolled up or down if the stock price is not in the profit zone. Put backspreads include at least one short contract. Therefore, assignment is a risk any time before expiration.
External factors may need to be considered when deciding to adjust or close a put backspread position. Suppose an investor wants to avoid assignment risk or extend the trade into the future to allow the strategy more time to become profitable. In that case, the entire position can be closed and reopened at a future expiration date with the same strike prices or new positions.
Rolling a Put Backspread
Put backspreads require the underlying stock price to be below a specific price at expiration. If the position is not profitable, and an investor wishes to extend the trade's length, the spread may be closed and reopened for a future expiration date. Because more time equates to higher options prices, the rollout may cost money and add risk to the position. The strike prices of the options in a put backspread may also be rolled up or down to reflect any change in price from the underlying asset.
Hedging a Put Backspread
It may be unnecessary to hedge put backspreads because the strategy is a risk-defined position with a clear payoff diagram. The strategy is bearish, and protection from higher movement in the underlying stock is not needed because the bull put spread defines the risk to the upside, and a sharp rise in the underlying security will result in a profit equal to the amount of credit received at entry.
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