When to use: Put Backspread Option Strategy is used when the investor is bearish on the stock (i.e. when the investor expects the stock price to fall in the near future).
How it works: In the put backspread strategy the investor sells 1 in-the-money put option; and buys 2 out-of-the-money put options of the same underlying stock with the same expiry date. The investor believes that the market will be bearish until expiry.
For example: On 20th August 2013, the share of Reliance Infrastructure Limited was trading at Rs. 334.30, you decide to sell 1 in-the-money put option with a strike price of Rs. 360.00 at a premium of Rs. 6.60. At the same time you buy 2 out-of-the-money put options with a strike price of Rs. 320.00 at a premium of Rs. 2.45.
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For Short put Option: If the price of the share stays above Rs. 360.00 (i.e. the strike price of the short put option) until expiry, you will retain the entire premium amount (i.e. Rs. 6.60). If however the price falls below Rs. 360.00, the buyer of the put option may exercise his option and make a profit based on how far above does the stock price fall. From the perspective of the seller of the put (you), you will start suffering a loss once the stock price falls below Rs. 353.40 (i.e. the strike price – premium).
For Long Put Options: If the price of Reliance Infrastructure share stays below Rs. 320.00 (i.e. the strike prices for the 2 long put options), you can exercise your options, but the price of the stock must fall below Rs. 317.55 (i.e. the strike price – the amount of premium you paid for each option) for you to exercise your option and make a profit.
Risk/Reward: In the put backspread strategy, your maximum risk will be limited (calculated as the difference between the strike price of short put and strike price of long putminus net premium received). The maximum reward which you stand to make from this trade will be limited if the price of the underlying stock goes up. On the other hand, if the price of the underlying stock goes down, then the maximum reward which you stand to make will be unlimited.
The table below clarifies the net payoff of the put backspread option strategy at different spot prices on expiry:
How to use the Put Backspread Option Strategy Excel calculator
Just enter your expected spot price on expiry, option strike price and the amount of premium, to estimate your net pay-off from the Put Backspread Option Strategy.
Note: The example and calculations are based assuming a single share though in reality options are based on lots of many shares. For example Reliance Infra’s option contract is for 1,000 shares. Accordingly the net premium received will be Rs. 1,700 for 3 lots (i.e. 1.70*1,000) in our example.
Also Note: Unlike the buyer of an option who only pays the premium to buy the option, the seller of an option must deposit a margin amount with the exchange. This is because he takes an unlimited risk as the stock price may rise to any level. In case the price rises sharply above the strike price, the exchange utilises the margin amount to make good the profit which the option buyer makes. The amount of margin is decided by the exchange and it typically ranges from 15 % to 60 % based on the volatility in the underlying stock and market conditions. In the above example, as a seller of put option, you will have to deposit a margin of Rs. 62,820.00 (i.e. Strike price * Lot size * 17.45%) for selling/writing a lot of Reliance Infra’s put option. Note that the total value of your outstanding position in this case will be Rs. 3,60,000 (i.e. strike price * lot size).