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The Backspread with Puts options strategy is best used if you are expecting a large move up or down, but are more bearish than bullish.

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Strategy: Backspread with Puts

Put Backspread Option Graph

The Outlook: Bullish or bearish, but not neutral. The stock must fall or rise for the strategy to gain.

The Trade: buy two Puts ATM and sell one Put ITM.

Gains when: stock rises or falls past the breakeven points.

Maximum Gain: Unlimited to the downside, limited to the upside.

Loses when: stock does not rise or fall enough.

Maximum Loss : limited to the difference in strike prices - the initial credit.

Breakeven Calculation: Lower breakeven = Long Put strike - difference in strike prices + initial credit. Upper breakeven = Short Put Strike - initial credit.

Advantages compared to short stock: limited risk, less capital needed, greater leverage, can gain from a move in either direction.

Disadvantages compared to short stock: Position will lose if stock does not move, or does not move enough.

Volatility: after entry, increasing implied volatility is positive if the stock does not move, or falls.

Time: after entry, the passage of time is negative if the stock does not move, or falls.

Margin Requirement: The difference in strike prices x the number of shares short represented, less the initial credit.

Variations: See the Backspread with Calls if you think there is a greater chance of a sharp rise in the stock price.

Comments

  • 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:
    • Is entered for a credit instead of a debit.
    • Has a lower maximum loss.
    • Cannot gain as much if the stock rises dramatically.
    • Has about the same profit potential to the downside.
  • Another similar strategy is a Reverse Butterfly constructed with all puts. Compared to a Reverse Butterfly using puts, the Backspread:
    • Is entered for less of a credit.
    • Has a greater maximum loss.
    • Needs more movement to be profitable.
    • Has much more profit potential to the downside.

Exits

  • Since 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.

Adjustments

  • 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 for more.

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