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Options: Improving Your Odds With Put Ratio Backspreads

Traders tend to view the put ratio backspread as a bear strategy, because it employs puts. However, it is actually a volatility strategy. So entering the position when volatility is high and waiting for the inevitable adjustment is a smart approach, regardless of the direction of price movement. Based on volatility and time decay, the strategy is a "price neutral" approach to options, and one that makes a lot of sense.

The position is a spread with limited loss potential, but varying profit potential. The degree of profit relies on the strength and rapidity of price movement. The position uses long and short puts in a ratio, such as 2:1 or 3:2, to maximize returns. In most long/short spreads, you make money if the stock moves, but you lose if it remains in the middle "loss zone." A ratio put backspread is different because it is set up with a net credit, so even if the stock price does not move very much, you keep the credit if all of the puts expire worthless.

The typical position combines buying at-the-money or out-of-the-money puts and, at the same time, selling a smaller number of in-the-money puts. Those in-the-money puts are always at risk of exercise, but you have two advantages. First, assignment can be covered by the long puts; second, time decay and volatility work in your favor on the short puts. This points out the importance of entering the position when implied volatility is higher than average.

The short position puts (which are in the money) will yield more premium income than the cost of the higher number of at- of out-of-the-money long positions. The ratio itself should vary depending on your belief in the strength, direction and timing of price movement, and also on the cost for each side. Creating a net credit is always desirable, so this also affects how many short and long puts you open.

Another issue is determining which strikes you should use in this strategy. The broader the strike difference between short and long puts, the fewer puts you need to sell to cover the price of the long puts. But at the same time, the coverage of long-to-short is going to be more difficult in the event of assignment. Thus, the most likely candidates for put ratio backspreads are stocks with 2.5-point increments or, better yet, one-point strikes. You are going to set up the spread around the current price level and expect some price movement to create maximum profits. However, with closer increments in the strikes, potential profits will develop more quickly.

For example, the underlying currently is priced at $84.29. A put ratio backspread is set up with the following trades:

Sell one ITM put, strike 84.50, bid 1.22 (minus trading fee, $9) = $113 credit

Buy two OTM puts, strike 84, ask 1.04, total 2.08 (plus $10 trading fee) = $218 debit

Net debit = $105

To calculate breakeven, the value of the long puts as to exceed the net cost of $105. The maximum profit is unlimited as long as the underlying price declines.

Another key point to make here involves how you judge volatility. Options traders often are told to use implied volatility, which is an estimate of future levels. However, historical volatility is more certain and is easily spotted on a price chart. When price expands and the trading range becomes larger, volatility is higher - and voice versa. This is also easily pictured by overlaying Bollinger Bands over price. The bandwidth from upper to lower band is a representation of current volatility. When this is wider than average, the timing of a put ratio backspread is ideal. Anticipating a declining level of bandwidth (historical volatility) makes sense.

Why use historical volatility? It is easily calculated with accuracy, unlike implied volatility which relies of estimates. Historical volatility is easily visualized with indicators like Bollinger Bands, so timing of the strategy is not complicated.

For anyone who has not entered a put ratio backspread in the past, it makes sense to experiment with varying levels of strikes and ratios. Paper-trade the put ratio backspread to experience how profits or limited losses develop, and how time to expiration affects both implied volatility adjustments and premium levels.

Michael Thomsett blogs at TheStreet.com, Seeking Alpha, and several other sites. He has been trading options for 35 years and has published books with Palgrave Macmillan, Wiley, FT Press and Amacom, among others. He also teaches on the Candlestick Forum website. To check membership, go to Candlestick Forum membership.