**Introduction To Put Backspread Option Strategy**

A put backspread options trading strategy involves selling some puts at a certain strike price and buying more puts at a lower strike price on the same underlying security with the same expiration date. Because there are more long puts than short puts in this strategy, the strategy is bearish on the underlying security, limits risk and has unlimited profit potential at the same time. The strategy can be executed with a net debit and at times, a net credit.

**Steps**

Step 1 : Perform economic, fundamental and technical analysis

Step 2 : Outlook – Extremely Bearish

Step 3 : Study the option chain

Step 4 : Breakeven Analysis

Step 5: Understand Your Profit Zones

Step 6 : Limited loss

Step 7 : Loss calculation

Step 8 : Unlimited profit potential

Step 9 : Profit calculation of a put backspread

Step 10 : Calculate Risk & Reward Ratio

Step 11 : Set Up Trade

Step 12 : Exiting the put backspread

Step 13 : Record Trade In Diary

**Step 1 : Perform economic, fundamental and technical analysis**

Before an options trader executes a put backspread, he must conduct economic, fundamental and technical analysis. Through his analysis, he must ascertain that the general market and the price of the underlying security is going down. Some of the chart patterns option traders are looking out for are:

**Read :** Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis

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**Step 2 : Outlook – Extremely Bearish**

The put backspread strategy is a bearish strategy. The trader that executes the put backspread projects that the price of the underlying security will reduce drastically in the near term and it will trade with increased volatility, within the remaining life of the options. Depending on how the put backspread is structured, a put backspread may have a net credit. While a large directional move downwards may prove to be profitable, a large directional move to the upside may still prove to be profitable in instances where a net credit is collected. Hence, volatility plays a role in determining the profitability of a put backspread.

**Step 3 :Study the option chain**

Examine the option chain to find suitable options for the construction of a put backspread.

**Read : ** Learn to read and understand options chain

**Step 4 : Breakeven Analysis**

The upside breakeven price point is simply the : Short exercise(strike) price

The downside breakeven price point = Exercise price of long puts – [(higher strike – lower strike) x no. of short put contracts] + net credit or less net debit

The net credit is equivalent to the net premiums collected while a net debit refers to net premiums paid to initiate the trade.

**Step 5: Understand Your Profit Zones**

Profit increases as the price of the underlying security trades below the downside breakeven point.

**Step 6 : Limited loss**

The maximum loss of a put backspread strategy is limited because there are more long put contracts than short put contracts. Generally speaking, a loss occurs when the long puts expire worthless while the short puts expire in the money. The maximum loss occurs when the price of the underlying security is at the exercise price of the long put contracts.

**Step 7 : Loss calculation**

The maximum loss can be calculated as :

Positive difference between the exercise price of the short and long puts + commissions paid to the broker – net credit

** Step 8 : Unlimited profit potential**

There is unlimited profit potential for a put backspread when the price of the underlying security declines drastically. Since this put backspread strategy has a bias towards long puts in the form of more put option contracts being bought than sold, the whole idea is to profit from a stock’s decline.

**A profit is realisable when :**

Twice of the exercise price of the of long put – exercise price of short put + credit is greater than the price of the underlying security

**Step 9 : Profit calculation of a put backspread**

**The profit can be calculated as :**

Exercise price of long put x 2 – Price of the underlying security – Exercise price of short put + Net credit – Commissions paid to broker

**Step 10 : Calculate Risk & Reward Ratio**

The risk and reward ratio is calculated based on maximum loss and estimated profit. Calculate the risk and reward ratio to find out if the the risk reward ratio is attractive.

**Read more :** Understanding Risk/Reward Ratio For Option Traders

**Step 11 : Set Up Trade**

For every in the money put option contract shorted, long 2 out of the money puts on the same underlying security with the same expiration date.

**Step 12 : Exiting the put backspread**

- If the short options have little time value left of a quarter point or less, there is a high risk of being assigned. At this point, the trader should consider closing the put backspread.
- In general, close the trade if there is no more than 30 days to expiration, especially if the trader anticipates stagnant conditions from then.
- If the put backspread is reasonably profitable on paper, the trader may want to close and equal number of short and long positions. The remaining long position can be used to capture additional profits should a major price move occur.
- Close out the put backspread if the price of the underlying security is trading between the upside and the downside breakeven point and there is no more than 30 days to expiration of the options. This is especially so if there is little probability of the stock price making a major price move.
- Let the options expire worthless and collect the net credit of there is any when the price of the underlying security trades above the upside breakeven.

**Step 13 : Record Trade In Diary**

After the trade has been exited, the trade should be recorded and detailed in a diary. This helps a trader to track, analyse and compare his trades.

**Example Of A Put Backspread**

The price of TTT Corp is trading at $38. A trader is bearish on the security and decides to execute a put backspread where 2 out of the money puts are bought for every put options contract shorted. A net debit or credit may result. In this case, the trader shorts 1 December 40 put at $3 and longs 2 December 35 put at $1 each. The total credit is thus : $300 – $100 – $100 = $100

If the price of TTT trades at $35, the December 40 put will have an intrinsic value of $5 at expiration. At this price point, when the trader decides to buy to close the short positions, the loss on the December 40 put is : $500 – $300 = $200

The long December 35 puts expire worthless and the loss to these long positions are: $100 x 2 = $200

Hence the total loss is $200 + $200 = $400 if the price of TTT Corp trades at $35.

If the price of TTT trades at $30, the December 40 short put will have an intrinsic value of $1000 at expiration. The loss to the short positions is thus:

$1000 -$300 = $700

**The gain on the long puts is:**

($500 – $100) x 2 = $800

Hence, the total profit is :

$800 – $700 = $100

The lower the price of the underlying security, the greater the profits.

For example, if TTT trades at $20, the intrinsic value of the December 40 puts and December 35 put would be $2000 and $1500 respectively.

**The loss of the short put is thus:**

$2000 – $300 = $1700

**The gain on the long puts is :**

($1500 – $100) x 2 = $2800

**The total profit is thus:**

$2800 – $1700 = $1100

Hence, the lower the price of the underlying security, the greater the profit.

**Long Put & Put Backspread & Synthetic Long Put**

If a trader is very bearish on a security, he may opt to use the long put strategy instead.

**Read:** Execute A Long put: Profit from price movements to the downside & Execute A Synthetic Long Put : Bearish Strategy