Option Strategies Details

A trader who wants to speculate on a large decrease in price and an increase in volatility can open a Put Backspread. The trader may pay a small debit, receive a small credit, or even open the position for exactly $0.

Suppose stock XYZ is trading at $101. You forecast a large increase in XYZ price and an increase in volatility.

You open a 1x3 $101 / $93 Put Backspread (selling the $101 Put for a $3.75 credit and buying three (3) $93 Puts for $1.25 each) for exactly $0 to express this view. Your breakeven low XYZ price at expiry is any price above $101 (since you entered the position for $0 and all contracts would expire worthless). The low breakeven price is more complex to calculate but adheres to this formula:

Strike Price of Long Puts - (Width of Spread / (N - 1)) +/- Debit Paid/Credit Received

Where N is the number of Long Puts bought with the credit from the Short Put.

The low breakeven for this Put Backspread is $93 - ($8 / (3-1)) + $0 = $89. However, since the time component of your trade plan may not since the time component of your trade plan may not extend all the way to expiration you should be prepared to to close at a variety of XYZ prices as the market value of your 1x3 $101 / $93 Put Backspread changes.

The max loss on this position at expiry is the width of the spread ($101 - $93 = $8), which occurs if price is exactly the strike of the long Puts ($93). The max gain of a Put Backspread is theoretically calculated if XYZ price decreases to $0 and grows rapidly if the price of XYZ drops below the long Put strike, especially if that price decrease occurs in advance of expiry. The PnL of a Put Backspread relies heavily on XYZ price decreasing significantly, approximately 12% in this example, and can be very costly if XYZ price decreases less than your forecasted amount.

Let's walk through another example, this time with a 1x2 Put Backspread, to solidify this "large price decrease required" concept.

Suppose stock ABC is trading at $43. You forecast a large increase in XYZ price and an increase in volatility as well.

You open a 1x2 $45 / $40 Put Backspread (selling the $45 Put for a $4.20 credit and buying two (2) $40 Puts for $1.90 each) for a $0.20 credit to express this view. At expiry, if ABC price is above $45, all contracts expire worthless and your keep the $0.20 credit received. Your breakeven ABC downside price at expiry is $35.20 ($40 - $5/1 + $0.20 = $35.20), but since the time component of your trade plan may not extend all the way to expiration you should be prepared to to close at a variety of ABC prices as the market value of your 1x2 $45 / $40 Put Backspread changes. The max loss on this position at expiry is $4.80 (the width of the spread plus any credit received or minus any debit paid, $45 - $40 +$0.20 = $4.80), which occurs if ABC price is the same as the long Put strike of $40.