In this column, we've mainly looked at some of the standard option trades like bull put spreads and cash-secured puts.
Today, we are 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 but doesn't want to lose money on a potential bounce.
The advantage of using a backspread is a much lower cost than simply buying a put option. The positive vega also helps generate profits in the event of a sell-off.
Let's look at an example.
Assume a trader wants to protect against a big drop in Advanced Micro Devices.
Fast And Sharp Drop In AMD Works Best
A put ratio backspread will do well if AMD stock suffers a significant drop and will not lose any money if AMD stays flat or rallies.
The risk on the trade is a small, slow decline in the stock price. If a decline is to happen, a hard and fast drop is best for traders.
Let's look at an example:
- Sell 1 July 19, 150-strike put at $3.40.
- Buy 2 July 19, 140-strike puts at $1.25.
The trade can be placed for a net credit of $90. That's calculated by taking the credit received for selling the 150 put ($340) less the premium paid for the two 140 puts ($250).
If AMD stock stays above 150 at expiration, the trader keeps the small amount of premium.
Max Loss On AMD Stock Trade $910
The maximum loss occurs if AMD stock finishes at 140 on expiration day. In that case the trader would lose $910.
Traders calculated this by taking the difference between the short and long strikes x 100 ($1,000) and subtracting the premium received ($90). The maximum gain is unlimited up to the point the stock reaches $0.
This is an advanced trading strategy and not recommended for beginners.
The ideal scenario for the trade is a large drop (and associated rise in implied volatility) within the first two weeks. Otherwise, flat, or higher prices are fine, too.
AMD is scheduled to report earnings in late July, so there should be no earnings risk with this trade.
According to the IBD Stock Checkup, AMD stock is ranked No. 8 in its industry group. It has a Composite Rating of 85, an EPS Rating of 88 and a Relative Strength Rating of 82.
Please 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 X/Twitter at @OptiontradinIQ
