with Puts options strategy is best used if you are expecting a large move
up or down, but are more bearish than bullish.
option-info and options-graphs sites:
Outlook: Bullish or bearish, but not neutral. The stock must fall
or rise for the strategy to gain.
buy two Puts ATM and sell one Put ITM.
when: stock rises or falls past the breakeven points.
Gain: Unlimited to the downside, limited to the upside.
when: stock does not rise or fall enough.
Loss : limited to the difference in strike prices - the initial credit.
Calculation: Lower breakeven = Long Put strike - difference in strike
prices + initial credit. Upper breakeven = Short Put Strike - initial
compared to short stock: limited risk, less capital needed, greater
leverage, can gain from a move in either direction.
compared to short stock: Position will lose if stock does not move,
or does not move enough.
after entry, increasing implied volatility is positive if the stock
does not move, or falls.
after entry, the passage of time is negative if the stock does not
move, or falls.
Requirement: The difference in strike prices x the number of shares
short represented, less the initial credit.
See the Backspread with Calls
if you think there is a greater chance of a sharp rise in the stock price.
- The Backspread
with Puts can be used if you expect a sharp stock price movement one
way or the other, but are mostly leaning bearish. For instance, you
may expect such a movement at earnings time on a stock that historically
has large movements in reaction to the earnings report.
- If you
are purely bearish, buying a single ATM put would have a lower breakeven,
a lower maximum loss, and more profit potential. The Backspread only
makes sense if you want to capitalize on the possibility of a sharp
upward movement as well as a sharp downward movement.
- The strategy
has limited profit potential to the upside, so you don't want to be
"too" bullish. Use the Backspread
with Calls if you are more bullish than bearish.
- A somewhat
similar strategy is the Straddle Purchase.
Compared to a Straddle Purchase, the Backspread:
entered for a credit instead of a debit.
a lower maximum loss.
gain as much if the stock rises dramatically.
about the same profit potential to the downside.
similar strategy is a Reverse
Butterfly constructed with all puts. Compared to a Reverse Butterfly
using puts, the Backspread:
entered for less of a credit.
a greater maximum loss.
more movement to be profitable.
much more profit potential to the downside.
this strategy needs stock price movement to be profitable, if the stock
does not move as expected, it is best to exit the trade with less than
the maximum loss. Using the example graph, if the stock has not moved
within two weeks (and you were expecting the movement by then), you
can exit for a loss of about $100. If you just sit and wait, you may
have to take a loss of over three times that much - $342.
- If the
stock rises, and you were really expecting a drop, it may be best to
take whatever small gain or loss you have. Waiting could result in a
reaction back to the worst possible price range.
- If the
stock falls below the lower breakeven point
at any time, you will have a gain, but time will be working against
you, and there is always the possibility of a reversal. You will need
to decide if the stock is having a strong enough downward move to justify
holding the position.
- It is
possible, but not likely, that you can get two free or nearly free long
puts if the stock rises dramatically. Then you can close out just the
short put, making a gain that may pay for or come close to paying for
the long puts. Then you would need some sort of a reversal so the long
puts could recover some of their value. If you try to plan in advance
for this scenario, it probably won't occur often enough to be worthwhile.
But if you are in a Backspread trade anyway, it may pay to remember
it. See the Free Rides:
Guaranteed Winning Trading Strategies? page