What is Put Ratio Back Spread?

Last Updated: 10 Oct 2024

The universal truth of the financial market is volatility. Investors who are inexperienced fear volatility as they think it can lower the value of their investments. Volatility indeed lowers the assets’ prices but investors realize losses only if they panic and sell. Investors who have all of their investments in equities can only wait for the volatility to end until their investments appreciate again in value

However, professional investors believe that time is money in the financial market. In case the financial market is volatile, these investors use Options Trading to ensure they make a profit even when the prices of the securities are falling. However, when amateur investors research and learn about Options Trading, they get confused because of the numerous Options Trading strategies.

If you are one of them and want to learn a strategy that is effective in a volatile market, the Put Ratio Back Spread is an ideal strategy. But first, some terms to help you with the understanding of the put ratio back spread options strategy.

Some terms associated with Put Ratio Back Spread.

• Strike Price: The price at which the Options contract was initially bought or the pre-determined price.
• Spot Price: The current price of the underlying asset attached to the Options contract.
• Premium: It is the price you pay to the seller of the option for entering into the online trading options.
• In-The-Money (ITM) option: When the underlying asset price is higher than the strike price.
• Out-of-the-money (OTM) option: When the underlying asset price is lower than the strike price.
• At-the-money (ATM) option: When the underlying asset price is identical to the strike price of the options contract.

What is Put Ratio Back Spread?

Put Ratio Back Spread is an Options strategy that includes buying two out-of-the-money put Options and selling one in-the-money put option. As the name suggests, the strategy involves following a ratio to buy and sell the options. The commonly used ratios are 2:1, 3:2, or 3:1. The strategy is a three-legged options strategy and always involves three options to be bought and sold in different ratios.

The put ratio back spread is a bearish strategy and aims to profit from the volatility in the underlying asset price. An investor creates the put ratio back spread to have unlimited profit potential while mitigating the risk exposure. In a put ratio back spread is used for ‘net credit’ of premium when the market goes up, and if the market goes down, you stand to make unlimited profits depending on the price difference.

How to construct the Put Backspread?

If you feel the market can go down further shortly, here is how you can construct a put ratio back spread:

The underlying asset lot size, ratio, and expiry are the same for all three put options. Let’s assume the lot size is 80.

• Buy 2 OTM Put Options
• Sell 1 ATM/ITM Put Options

NIFTY’S current market price	Rs 7,300
Buying OTM Put strike price	Rs 7,200
Premium paid for OTM Put	Rs 50
Selling ATM/ITM Put strike price	Rs 7,300
Premium received for ATM/ITM Put	Rs 100
Upper Break-Even Point	Rs 7,300
Lower Break-Even Point	Rs 7,100

Net Premium Paid/Received = Rs 0 (100- (50×2))

If the underlying asset breaks the lower break-even point of Rs 7,100, the investor will realize maximum profit. However, the maximum loss will be limited to Rs 8,000 if the NIFTY expires at Rs 7,200.

When to initiate the Put Back spread?

As mentioned above, the put ratio back spread strategy is bearish and is executed by investors when the prices of assets are falling. For example, after analyzing various technical indicators such as moving averages, if the investors believe that the market is volatile and can become bearish, only then do they execute the strategy. As the profit potential is unlimited after the underlying asset falls below the lower break-even point, the put ratio back spread can allow investors to earn huge profits.

With limited risk and unlimited profit potential, using a put ratio back spread is how professional investors make profits even when there is panic because of falling prices. As the maximum loss is known upfront, there is no fear of losing what you can not afford. However, it is always wise to consult your stock broker before you implement the put ratio back spread strategy. IIFL’s expert financial advisors can advise you on the best ratio for the strategy, the current market trend, and how to use the put ratio back spread strategy along with other options strategies to profit in almost every market situation.You can visit IIFL’s website or download the IIFL online trading app from the app store to get started.

Frequently Asked Questions

1. Is Put Ratio Back Spread a good strategy?

Yes, a put ratio back spread strategy is one of the best and most widely used strategies by professional traders. As investors know the maximum loss they can incur beforehand; they can implement the strategy without the fear of huge losses. Furthermore, the maximum profit potential is unlimited in a put ratio back spread options strategy. It is one of the rare strategies that allow an investor to benefit from the falling prices or if the market is showing a bearish trend.

2. How to manage risk in Put Ratio Back Spread?

A put ratio back spread options strategy comes with limited risk. Before implementing the strategy, the investors know how much they will lose if the underlying asset breaks the upper break-even point. Hence, they only enter the strategy if they can afford the losses. Since the risk is limited, an investor can take an overnight position to manage further risk. Furthermore, investors can consult a financial advisor to seek expert guidance and get valuable insight regarding the market trend (whether it is just a correction or a bear market).