In this column, we’ve mainly looked at some of the standard option trades like bull put spreads and cash secured puts.
Today, we’re going to look at one of the less common option strategies, called a put ratio backspread. A put backspread involves selling a put and then buying two further out-of-the-money puts.
This strategy is used when a trader is expecting a large drop in a particular stock. The advantage of using a backspread is a much lower cost than simply buying a put option.
There is always a trade-off of course, and that comes in the form of a “valley of death” you can see in the below payoff diagram.
Let’s look at an example.
Assume a trader thinks Boeing (BA) stock is likely to experience a big drop in the next few months. A put ratio backspread might be set up as follows:
Sell 1 April 16 210 put @ 12.25
Buy 2 April 16 190 puts @ 5.25
The trade can be placed for a net credit of $175 calculated by taking the credit received for selling the 210 put ($1,225) less the premium paid for the two 190 puts ($1,050). If BA stock stays above 210 at expiration, the trader keeps the small amount of premium.
The maximum loss occurs if BA stock finishes at 190 on expiration day in which case the trader would lose $1,825 on the trade. This is calculated by taking the difference between the short and long strikes x 100 ($2,000) and subtracting the premium received ($175).
Backspreads Are Advanced Options Trades That Are Good For Volatility
The maximum gain is unlimited up to the point the stock reaches $0. The break-even prices are 171.25 and 208.25.
This is an advanced trading strategy and not recommended for beginners.
I wouldn’t hold this trade for more than two weeks just in case the stock gets sucked down into the valley of death. The ideal scenario for the trade is a huge drop (and associated rise in implied volatility) within the first two weeks.
Earnings for Boeing stock is set for April 28, so there is no earnings risk with this trade.
BA stock has a Composite Rating of 6, an EPS Rating of 4 and an RS Rating of 33.
It’s important to remember that options are risky and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
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View more information: https://www.investors.com/research/options/ba-stock-advanced-options-trading-strategy/