Put backspread

Hi guys

Bear with me here as totally new to options.

Best to illustrate with an example :
( all values theoretical and keeping in mind IV and theta - both of which I know v little about !)

FTSE 100 futures now 5266

I buy 4800 puts to expire Dec 11
I sell 5100 puts to expire Dec 11

Assume the premium received for sold options is greater than for the ones bought so its a credit spread. I am hoping for a big move down by Dec to take out 4500 (say).

But it does not happen. FTSE starts to move up like it is now. And by expiry the maket is at 5550.
As I understand it from Natenberg`s book - at expiration all options expire worthless and I keep the credit.

I have 2 questions -

1) But surely the 5100 puts I shorted make more money as I am artificially long ? Is this counteracted by the loss in value of the 4800 puts I am long ?
Hence a spread....:idea:

2) More interestingly, what happens if the market finished at expiry at say 4900, ie below 5100 but above 4800 ? Same result, all expire worthless and I keep the credit ?

I realise this throws up a lot of issues like time to expiry ( ideally I would like to put this spread on in Nov for about 4 weeks.....), bid ask spread, cost of the legs etc....

Thanks a bunch comrades
CT.

I don't follow your preamble.

If you sell 5100 puts, buy 4800 puts, and anticipate a move to 4500, and that happens, then you are going to lose money at expiry, regardless of the pain you will experience in the interim. Your long 4800 put is worth [300], and the 5100 you shorted is worth [-600]. You are a net seller of options with this spread and when the options finish in the money, you lose.

Assuming FTSE rises from here to 5550 at expiry:

1) initial cost of 5100 put > initial cost of 4800 put, and you pocket the difference (which you were paid on day 1).

Assuming FTSE falls to 4900 at expiry:

2) you lose [-200] on the 5100 put you sold, and your 4800 put expires worthless.

But this is without getting into the interim dynamics. I wouldn't recommend selling options - you are basically selling insurance, and if things go badly, they can go really badly.

You're selling a put spread, like Dommo says... Just draw a payoff diagram and you'll get all your questions answered.

combotrader said:

Hi guys

Bear with me here as totally new to options.

Best to illustrate with an example :
( all values theoretical and keeping in mind IV and theta - both of which I know v little about !)

FTSE 100 futures now 5266

I buy 4800 puts to expire Dec 11
I sell 5100 puts to expire Dec 11

Assume the premium received for sold options is greater than for the ones bought so its a credit spread. I am hoping for a big move down by Dec to take out 4500 (say).

But it does not happen. FTSE starts to move up like it is now. And by expiry the maket is at 5550.
As I understand it from Natenberg`s book - at expiration all options expire worthless and I keep the credit.

I have 2 questions -

1) But surely the 5100 puts I shorted make more money as I am artificially long ? Is this counteracted by the loss in value of the 4800 puts I am long ?
Hence a spread....:idea:

2) More interestingly, what happens if the market finished at expiry at say 4900, ie below 5100 but above 4800 ? Same result, all expire worthless and I keep the credit ?

I realise this throws up a lot of issues like time to expiry ( ideally I would like to put this spread on in Nov for about 4 weeks.....), bid ask spread, cost of the legs etc....

Thanks a bunch comrades
CT.

Click to expand...

this is a very bullish trade and can be a very dangerous type of trade if you are wrong and i wouldn't recommend that you try to make this sort of trade as a beginner especially. this is not a type of trade where you hope to have the market come down hard and volatility increase because your short options will destroy you account, especially if you are opening this type of trade with a credit.

consider adding another leg perhaps? or put this one in your practice account and see how it acts. take a good hard look at the risk graph before anything or post a pic on here so we all can see exactly what you are talking about.

Thanks for all the replies.

What Dommo says makes perfect sense.

What is confusing me is why Natenberg adovocates this in his book as a put back spead. He writes and I quote page 139 : A put backspread consists of long puts at a lower exercise price and short puts at a higher exercise price.

Options with smaller deltas are bough and those with lower deltas are sold - it has to be delta neutral, all options expiring at the same time.

Maybe I have put the strikes and the underlying prices wrong......

Spaciba ( thanks) comrades

In the spread he describes, the long option mitigates downside from the short, but you could still potentially lose many times the premium you receive.

For me the ongoing costs/difficulties of hedging make option selling unattractive/unviable unless (i) you have the benefit of being paid to do it with a bank's money; (ii) you have an extraordinary talent for predicting vol and price paths, or (iii) very deep pockets.

How can being short a put spread be delta neutral (unless it's ratio'd)? I think you must have misread that bit...

I think the next section in the book deals with the ratio vertical spread......this is about the put and call backspread....

Is this book not meant to be the bible for option traders ? When my cousin worked for UBS they made him read this and learn the greeks inside out first few days.....strange to see it containing poor strategies. And I have quited verbatim from the book - this strategy is not mine !

WOndering if it would be better if, expecting the market to go down I bought the 5100 put and sold the lower one at 4800, ie the reverse of what it is now...

There's no such thing as a "poor"/"good" strategy. There's nothing inherently wrong with selling the put spread. The problem with all such trades is always the size/leverage of your particular position. You just have to understand exactly what you're doing and what your risk and downside are.

The best situations for a backspread I've studied are among the following:

- Highest possible ratio of options bought to options sold.
- The difference in strikes must be as small as possible.
- The option sold has much higher IV than the options bought.
- The underlying MUST be volatile! You want as much movement as possible.
- However, you want a large difference in the volatility between option strikes.

Highest loss is calculated like a credit spread, except that you account for the extra debit paid on the options bought. In general, if the UL ends up anywhere between the strikes, you lose.

The advantage of this type of spread is that so long as the underlying moves outside of the strikes of the spread, you have the possibility of making money. If the UL moves against you, you will receive a credit for letting the spread expire. If the UL moves in your favour, the ratio of options bought eventually outweighs the short options.

While a theoretically desirable spread, it's difficult to find an optimal trade. If the UL has too much IV, there won't be enough difference between strike prices to construct the spread without going deep ITM which is not recommended at all. Time value also eats at the long options like a mother, and the UL might not move enough to offset the short delta.

However, in the cases where an explosive move is anticipated (earnings, for example), it can be a good trade. Just practice this spread for a good long while before using it to really understand what it can and cannot do and how it can wreck your account if not careful.

Who said anything about ratio spreads? I thought the discussion had been about 1:1 all along...

^ A backspread is the opposite of a ratio write, where you purchase more long options than you sell.

For example, selling a lower strike call for 4 to purchase two higher strike calls for 1.75. You make a 1:2 ratio that way (though as I said in my previous post you want to make this ratio as high as possible. Imo, you want 1:3 at a minimum).

... Unless the OP meant something else...

Thanks I was talking about a bull put backspread.

Looking back I have actually constructed it wrong - I should have bough the lower strike put (4800) and sold the higher strike put ( 5100). As long as ftse stayed above 5100 at expiry i would have made money.

Correct ?

Yeah, so this is just selling the put spread (I prefer this terminology to the whole "bull put backspread" malarkey). And yes, if FTSE is above 5100 at expiry, you pocket the entire premium.