Derivatives

Put-based spread strategies for bearish plays

Venkatesh Bangaruswamy | Updated on February 27, 2021

Apt for taking advatage of a bearish view on the underlying

In the past two weeks, we discussed how to set up ratio spread and backspread to take advantage of a bullish view on an underlying. This week, we discuss how the same two strategies, this time using puts, can be utilised to take advantage of a bearish view on an underlying.

Put spreads

A bear ratio spread is a short put combined with a bear put spread. Suppose an underlying trades at 14,700 and is expected to decline to 14,550. A bear ratio spread can be setup by going long one contract of a higher strike (14,700) put and shorting two contracts of a lower strike (14,500) put on the same underlying for the same maturity.

The position enjoys maximum profit if the underlying trades at 14,500 at option expiration. The maximum profit will be the difference between the strikes less the net debit (cost to set up the spread). If the position is set up for a net credit, the maximum profit will be the difference between the strikes plus the net credit. The breakeven for above position is 14,270, which is lower strike (14,500) less the difference between the strikes (200 points) less net credit (30 points). This position will incur large losses if the underlying declines below the breakeven.

But if you have a view that the underlying will decline sharply, you should set up a put backspread. In a backspread, you short one contract of a higher strike put (14,700 put) and go long on two contracts of a lower strike put (14,500 put). The position will generate profits when the underlying moves below the breakeven of 14,270, which is the lower strike (14,500) less the difference between the strike (200 points) less the net debit to setup the spread (30 points).

Note that backspread will generate profits when the underlying declines below 14,270, whereas the bear ratio spread will generate losses below this price. This is because backspread is the opposite side of the bear ratio spread.

You can apply the following rules to set up these strategies: If you have a view that the underlying is likely to decline slowly and that the current implied volatility is high, then a bear ratio spread would be optimal. If you hold a view that the underlying is likely to decline sharply and that the current implied volatility will explode (increase), then a put backspread would be meaningful.

In both cases, the higher strike put can be the at-the-money (ATM) put. This is because both positions also bet on a change in implied volatility and ATM option has the highest vega, which is the change in option price for a one percentage point change in implied volatility.

Optional reading

A bear ratio spread benefits from time decay. Note that time value of an option is a combination of time to maturity and implied volatility. Therefore, a decline in implied volatility will accelerate the time decay as the option approaches maturity. A backspread, in contrast, benefits from increase in implied volatility.

Both the bear ratio spread and the put backspread require additional capital because of margin requirements on the short put. Both positions are complex compared to a bear put spread, which involves buying a higher strike put and shorting a lower strike put. A bear ratio spread will generate greater profits than a bear put spread if the underlying trades at the short (lower) strike at option expiration. This is because the additional short put in a bear ratio spread can translate to a lower net debit or to a net credit.

Finally, unlike a bear put spread which limits the profit to the difference between the strikes less the net debit, a put backspread can generate greater profits when the underlying declines sharply. But beware, the maximum loss on both a bear ratio spread and a put backspread is greater compared to a bear put spread.

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Published on February 27, 2021
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