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Options trading is hardly a piece of cake. Not only is the fundamental concept behind derivatives like those difficult to understand for a lot of people, what is even more challenging is putting these options to use to exploit certain specific market conditions.
A put option back spread, also known as a bull put credit spread, is a trading strategy that uses the asset’s price dip as an opportunity to profit. In this article, we’re going to look at this strategy in detail and understand everything you need to know about it before you put it to use with real money.
Components of a put option backspread
A put backspread is like a mini-insurance policy on a stock you think will go down. You sell one put option someone wants to buy (gives you a credit), but to hedge your bets, you also buy two put options at a lower price (like a backup insurance). This way, you limit your risk while still having the chance to profit if the stock price tanks.
Example of a payoff
Imagine you think the price of TechCorp (TECH) stock is going to fall. Let’s say TECH is currently trading at $50. Here’s how a put backspread could play out:
- Sell one put: You sell a put option with a strike price of $45 (in-the-money because it’s lower than current price) and receive a premium of $5 (this is the credit that reduces your risk).
- Buy two puts: You also buy two put options with a strike price of $40 (out-of-the-money because it’s lower than current price) for a total cost of $3 each (let’s say $6 for both).
Now think about the two things that could happen after you execute this strategy:
- Stock falls below $40: If TECH falls significantly, say to $30, both your long puts ($40 strike) become profitable, and you can exercise them to sell the stock at $40 and immediately buy it at the market price ($30), making a profit. You have to realise some losses on your short put in this case.
- Stock falls moderately: Even if TECH only falls to $42, your short put ($45 strike) does not get exercised, and you keep the premium ($5). You might lose a little on the long puts ($40 strike) that expire out-of-the-money, but your overall loss would be limited (difference between strike prices – premium received).
In this case, you stand to lose the most money if the stock price falls to exactly the strike price of your long puts. This would mean that your short put would get exercised, so you lose money, and your long puts have no intrinsic value.
However, there is unlimited upside if the stock keeps falling in price because you’re long two puts compared to one short put.
This is what the payoff diagram would look like
How do you exit 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.
The amount of your profit or loss will largely depend on your entry prices. If the stock price is above the short put option, all contracts will expire worthless and no action is needed from your end. The premium you receive will remain, but you will also have to pay two premiums in return.
Things to keep in mind when executing advanced option strategies
- These are not risk-free: The elaborate strategy and payoff graph could lead you to believe otherwise, but these are not risk-free. You can still lose money if the stock price goes against you significantly.
- Strike selection is no child’s play: Carefully choose the strike prices for your short (ITM) and long (OTM) puts. This significantly impacts your risk/reward potential.
- Time decay (theta): Put backspreads are especially vulnerable to time decay, especially the long puts. As time passes, their value will erode even if the stock price itself stays flat.
- Commissions: Put backspreads can benefit from volatility because you make money when the stock moves violently downwards. However, you could also end up losing money if it starts moving in the other direction.
Frequently Asked Questions
While the profit potential is theoretically unlimited if the stock plummets, it’s more realistic to target a specific profit range. This depends on the chosen strike prices and the premium received.
This is the main risk of a put backspread. Unlike buying a single put, your profits are capped. If the stock price rises significantly, you’ll lose money on both the short put (assigned the stock if it breaches the strike price) and potentially the long puts (expire worthless).
Time decay (theta) eats away at the value of your long (OTM) puts. Choose an expiration date that aligns with your expectation for the stock’s price movement. A shorter time frame might be suitable for a more aggressive play.
This scenario can be disadvantageous for put backspreads. The time decay will erode the value of your long (OTM) puts even if the stock dips slightly.
Unlike buying a naked put, a put backspread requires less upfront capital. You’ll need the initial margin for the short put (which can be partially offset by the credit received) and the cost of the long puts.
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