Understanding
Stock Options Trading
and Technical Analysis Basics

Put Backspread

Backspreads, also known as reverse ratio spreads, are an option strategy utilized when you believe there will be much volatility in the stock but are not 100% sure whether it will go up or down. If the stock moves a lot in the predicted direction, you will earn a tidy profit. If the stock moves a lot, but in the opposite direction, you will earn a small profit. However, if the stock doesn't move much, you will experience a loss. They are called reverse ratio spreads because they are created and behave the opposite of ratio spreads.

The backspread position used when you are bearish on the stock is known as a Put Backspread or Put Ratio Spread, since put options are used to create this position. The put backspread is opened by buying any number of out-of-the-money (OTM) put options (i.e. put options whose strike price is below the current stock price, and selling a smaller number of in-the-money (ITM) put options (i.e. put options whose strike price is above the current stock price). Doing this should give you a net credit premium.

A put backspread can be created by buying and selling any number of put options, but for this article we will talk about the simplest case, which is selling 1 ITM put option and buying 2 OTM put options.

Put Backspread - Buy 2 OTM Puts, Sell 1 ITM Put
Put Backspread - Buy 2 OTM Puts, Sell 1 ITM Put

If the stock moves above the strike price of the ITM put option you sold, you can allow the position to expire and keep your original credit premium, since all 3 put options will be worthless. If the stock price ends up between that ITM strike price and the strike price of the 2 OTM put options you bought, then you will incur a loss, since you will need to buy back the ITM put option which is now worth something, but the 2 OTM put options are still worthless.

Once the stock price drops below the strike price of the OTM put options, you will start to see unlimited profit since the cost of buying back the ITM put option is more than offset by the profits from selling the 2 OTM put options.

Summary:

A Put Backspread or Put Ratio Backspread is opened by buying 2 OTM put options and selling 1 ITM put option, earning you a net credit premium. This position is for high volatility with a bearish outlook. If the stock climbs, you keep your credit premium, if the stock falls, you earn unlimited profits. However, if the stock price doesn't move, you will incur losses due to buying back the put option you sold.

A Call Backspread functions the same way but in the opposite direction, and is a bullish position. It is created by buying and selling call options rather than put options.

Do bear in mind that you cannot allow a backspread position to expire, since you have sold options that need to be bought back to prevent them being exercised. As such, you will need to make sure you have enough funds to buy back those options in case the stock price doesn't move.