Understanding The Put Ratio Back Spread Strategy – Net Debit

In the previous issue, we introduced Put Spread Strategies with the Put Ratio Back Spread (Net Credit). Now, we move forward by exploring the Put Ratio Back Spread (Net Debit)—a strategy that allows traders to take advantage of sharp bearish movements while managing risk effectively 

Let’s delve into how our fictional investor and trader Sarvani Shah applies this strategy and why it fits her current market outlook.

What is a Put Ratio Back Spread (Net Debit)?
The Put Ratio Back Spread (Net Debit) is a bearish options strategy where:
• One in-the-money (ITM) put option is sold
• Two out-of-the-money (OTM) put options are bought.

Unlike the Net Credit variant, this strategy requires an upfront cost (net debit) because the combined price of the two bought puts exceeds the premium received from the sold put. It is ideal for traders expecting a strong bearish move.

Why Put Ratio Back Spread (Net Debit)?
This strategy is suitable for traders who:
• Anticipate Strong Downside Move: Profits increase as the underlying asset drops significantly.
• Seek Higher Profit Potential: Unlimited profit potential below the lower breakeven point.
• Prefer Defined Risk: The maximum loss is limited to the net debit paid, unlike naked put selling.

For Sarvani, this strategy aligns with her expectation that Nifty may experience a steep decline soon.

Executing the Put Ratio Back Spread (Net Debit)
Here’s how Sarvani set up her position:
• Nifty Current Market Price: 22,850
• Sell 1 Lot ITM Strike 22,900 PE Price: ₹250
• Buy 2 Lots OTM Strike 22,700 PE Price: ₹160 each
• Expiry Date: February 27, 2024.

Sarvani sells one ITM put at ₹250 and buys two OTM puts at ₹160 each, resulting in a net debit of ₹70 (₹320 paid - ₹250 received).

Breakeven Points
The Put Ratio Back Spread (Net Debit) has two breakeven points:
1. Upper Breakeven Point (UBEP): Strike Price of Sold Put + Net Debit Calculation: 22,900 + 70 = 22,970
2. Lower Breakeven Point (LBEP): Strike Price of Bought Put - Strike Price Difference - Net Debit Calculation: 22,700 - 200 - 70 = 22,430.

Sarvani’s profit begins when Nifty falls below 22,430, with unlimited gains on further declines.

Payoff Structure
The payoff for the Put Ratio Back Spread (Net Debit) depends on Nifty’s closing price at expiry:
1. If Nifty remains above 22,970:
• All options expire worthless.
• Sarvani incurs the maximum loss, equal to the net debit paid.
• Maximum Loss: ₹70.

2. If Nifty is between 22,430 and 22,970:
• The sold ITM put incurs losses, offset by the gains in bought OTM puts.
• Net payoff varies depending on the exact price.

3. If Nifty falls below 22,430:
• The bought OTM puts generate unlimited profit as the market declines.

This table highlights how Sarvani’s loss is limited, but the profit potential is unlimited if Nifty moves sharply downward.

Put Ratio Back Spread (Net Debit) vs. Put Ratio Back Spread (Net Credit)
1. Cost Structure:
• Net Debit Variant: Requires an upfront premium payment, as the cost of the bought puts exceeds the premium received from the sold put.
• Net Credit Variant: Generates an upfront credit, as the premium received from selling the ITM put is higher than the cost of the bought OTM puts.

2. Market Outlook:
• Net Debit Variant: Best for highly volatile bearish markets where a significant downside move is expected.
• Net Credit Variant: Suitable when traders expect a gradual decline or want to profit from range-bound price action while still being positioned for a sharp fall.

3. Profit Potential:
• Net Debit Variant: Offers unlimited profit potential below the lower breakeven point with lower probability of success.
• Net Credit Variant: Also offers unlimited profit potential below the lower breakeven point with higher probability of success.

4. Risk Profile:
• Net Debit Variant: Limited risk—the maximum loss is the net debit paid, even if the market moves against the position.
• Net Credit Variant: Limited risk on the upside, but the risk of losing the entire net credit zone is higher if the market stays within narrow range.

Conclusion
The Put Ratio Back Spread (Net Debit) is an effective strategy for traders like Sarvani who expect strong downward momentum in the market. By paying an initial debit, she positions herself for unlimited profit if Nifty experiences a significant decline. This strategy works particularly well on high beta underlying assets, as they exhibit strong directional movements over time. However, traders should avoid applying this strategy to low beta stocks or indices, as they typically trade within range-bound price swings.

The main point of concern in this strategy is correctly predicting direction and ensuring the market moves beyond the lower breakeven to generate profits. By carefully selecting strike prices and monitoring market conditions, Sarvani continues refining her trading approach, ensuring she remains adaptable in both bullish and bearish scenarios. With this strategy, she maintains limited-risk exposure while preparing for high-reward opportunities in a declining market.