Understanding The Put Ratio Back Spread Strategy – Net Credit

In this issue, we begin exploring put spread strategies, following our deep dive into call spreads in the last four issues. Our focus today is on the Put Ratio Back Spread (Net Credit)—a powerful strategy designed for bearish market conditions with a potential for significant gains if the underlying asset declines sharply 

Let’s explore how our fictional investor Sarvani Shah applies the Put Ratio Back Spread (Buy More) in her trading journey and why she prefers this net credit variant. First of all, let us understand the meaning of a Put Ratio Back Spread (Net Credit). This is an options strategy that benefits from sharp downward movements in the market. It involves:

1. Selling one in-the-money (ITM) put option.
2. Buying two out-of-the-money (OTM) put options.

Since the ITM put option is sold at a higher premium than the cost of buying two OTM puts, this strategy results in a net credit. The trader collects an upfront premium while positioning themselves to gain from strong bearish moves.

Reasons for Using Put Ratio Back Spread (Net Credit)
This strategy is particularly suitable for traders who:
1. Expect high volatility on the downside : Profits increase as the underlying price drops significantly.
2. Want an upfront credit : The net credit ensures that the trader benefits even if the market remains neutral or slightly bullish. For Sarvani, this strategy aligned with her view that Nifty could experience a sharp decline in the coming weeks.

Executing the Put Ratio Back Spread (Net Credit)
Here’s how Sarvani set up her position:
• Nifty Current Market Price: 23,360
• Sell 1 Lot ITM Strike 23,600 PE Price: ₹400
• Buy 2 Lots OTM Strike 23,100 PE Price: ₹190 each
• Expiry Date: February 27, 2024.

Sarvani sells one ITM put at ₹400 and buys two OTM puts at ₹190 each, resulting in a net credit of ₹20 (₹400 received - ₹380 paid).

Breakeven Points
The Put Ratio Back Spread (Net Credit) has two breakeven points:
1. Upper Breakeven Point (UBEP): Strike Price of Sold Put - Net Credit. Calculation: 23,600 - 20 = 23,580.
2. Lower Breakeven Point (LBEP): Strike Price of Bought Put - Strike Price Difference + Net Credit. Calculation: 23,100 - 500 + 20 = 22,620.

Sarvani’s profit zone begins when Nifty falls below 22,620, with unlimited profit potential on sharp declines.

Payoff Structure
The payoff for the Put Ratio Back Spread (Net Credit) depends on Nifty’s closing price at expiry:
1. If Nifty remains above 23,580
• All options expire worthless.
• Sarvani retains the net credit as her maximum profit.
• Profit: ₹20.

2. If Nifty is between 23,580 and 22,620
• The sold ITM put incurs losses, offset by the bought OTM puts.
• Net payoff varies depending on the exact price.

3. If Nifty falls below 22,620
• The bought OTM puts gain substantial value, while the loss on the ITM put is fixed.
• Unlimited profit potential as Nifty declines further.

This table illustrates Sarvani’s profit potential and risk exposure at different expiry prices.

Put Ratio Back Spread (Net Credit) vs Call Ratio Back Spread (Net Credit)

Both the Put Ratio Back Spread (Net Credit) and Call Ratio Back Spread (Net Credit) follow a similar structure—selling one ITM option and buying two OTM options while collecting a net credit. However, their market expectations and payoff structures differ significantly:

1. Market Outlook:
• Put Ratio Back Spread (Net Credit): Designed for a bearish outlook with high volatility.
• Call Ratio Back Spread (Net Credit): Best suited for a bullish outlook with high volatility.

2. Profit Potential:
• Put Ratio Back Spread (Net Credit): Unlimited profit potential if the market falls sharply.
• Call Ratio Back Spread (Net Credit): Unlimited profit potential if the market rises significantly

3. Risk Profile:
• Put Ratio Back Spread (Net Credit): Capped risk if the market moves upward beyond the upper breakeven point.
• Call Ratio Back Spread (Net Credit): Capped risk if the market moves downward beyond the lower breakeven point.

4. Breakeven Levels:
• Put Ratio Back Spread (Net Credit): Lower breakeven is closer to the OTM puts, allowing profits to build as the market falls.
• Call Ratio Back Spread (Net Credit): Upper breakeven is closer to the OTM calls, allowing profits to grow as the market rises.

Sarvani had previously explored the Call Ratio Back Spread (Net Credit) when she was bullish, but with Nifty showing signs of weakness, she transitioned to the Put Ratio Back Spread (Net Credit) to capitalise on the bearish sentiment.

Conclusion
The Put Ratio Back Spread (Net Credit) is an effective strategy for traders like Sarvani who anticipate potential downside but want to maintain a safety cushion in case the market remains stable. The ability to generate an upfront credit while positioning for unlimited profit on a market drop makes this strategy attractive. This strategy works particularly well for underlying which experience directional movements over time, making it a valuable tool for traders.

As Sarvani continues refining her trading approach, she recognises the importance of selecting the right options strategy based on market conditions. With a structured approach and a clear understanding of risk, she remains confident in her ability to navigate bearish scenarios efficiently.