Put Diagonal Ratio Backspread

How Does The Put Diagonal Ratio Backspread work in Options Trading?

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Put Diagonal Ratio Backspread - Introduction

Put Diagonal Ratio Backspreads, also known as Put Calendar Ratio Backspreads, are Ratio Backspreads, which means volatile options strategy. Backspreads profit when the underlying stock breaks out to upside or downside and loses money when the stock remains stagnant. This is what happens with the Put Diagonal Ratio Backspread but with a slight twist. Put Diagonal Ratio Backspreads are credit spreads but retained the unlimited profit potential of debit volatile options trading strategies! Yes, credit backspreads such as the Short Butterfly Spread and Short Condor Spread have only limited profit potential, whereas the Call Diagonal Ratio Backspread has unlimited profit potential when the stock breaks out to upside and limited profit potential when the stock breaks out to downside, opening up one direction for unlimited profit. This tutorial shall cover how Put Diagonal Ratio Backspreads work, when to use it, how to use it and its advantages and disadvantages.

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More a Bearish Strategy than a Volatile Strategy

The Put Diagonal Ratio Backspread is a diagonal ratio spread. Even though the Put Diagonal Ratio Backspread is technically a volatile options trading strategy due to the fact that it can profit either upwards or downwards, it does has a strong directional bias, which is downwards. Yes, Put Diagonal Ratio Backspreads can be better understood as a bearish options strategy which still makes a limit amount of money even if the stock goes up strongly. It makes an unlimited profit if the stock goes down and a small profit if the stock goes up. Of course, like all bearish options trading strategies, it loses money if the stock stays still. If understood this way, the Put Diagonal Ratio Backspread becomes the only credit bearish options strategy to have unlimited profit potential. Indeed, the Put Diagonal Ratio Backspread does empitomize the versatility and flexbility of ratio spreads, creating unique options trading risk/reward profiles.

Comparing Put Diagonal Ratio Backspread with Put Ratio Backspread

So, how does the Put Diagonal Ratio Backspread compare with its cousin, the Put (Vertical) Ratio Backspread? Both Put Diagonal Ratio Backspread and the Put Ratio Backspread share the exact same risk/reward profile and used in largely the same situations, so what set them apart?

In terms of how both options trading strategies are set up, the Put Diagonal Ratio Backspread buys further month put options while the Put Ratio Backspread buys put options of the same month as the put options that are being shorted. The using of options with different expiration month and strike is what makes the Put Diagonal Ratio Backspread a Diagonal Spread.

Example: Assuming QQQQ at $44. Put Diagonal Ratio Spread : Buys 2 contracts of February44Put, Sells 1 contract of January50Put Put Ratio Spread : Buys 2 contracts of January44Put, Sells 1 contract of January50Put

Because Put Diagonal Ratio Spread buys further term put options than the Put Ratio Backspread, it incurs a higher cost as the longer term put options are more expensive and consequently makes a lower net credit than the Put Ratio Backspread as well as a lower profit when the stock rallies.

So, what's the advantage of the Put Diagonal Ratio Backspread?

The Put Diagonal Ratio Backspread's only advantage lies in the fact that if the stock did not move on the immediate month, it can write new options against it in the following month and have a second chance at the stock breaking out again! Yes, having a much higher holding power and waiting power greatly increases the chances of the Put Diagonal Ratio Backspread winning versus the Put Ratio Backspread at the cost of lower profits. Yes, this is the kind of trade-off that you get all the time in options trading. If you are very confident of a quick breakout, then you would naturally maximize your profits by using the Put Ratio Backspread instead.

When To Use Put Diagonal Ratio Backspread?

One should use a Put Diagonal Ratio Backspread when one is confident in a strong drop in the underlying instrument , wishes to profit from that drop without any upfront payment , not lose any money should the stock rises instead and wants to give the stock more time to perform that bearish breakout .

How To Execute Put Diagonal Ratio Backspread?

The Put Diagonal Ratio Backspread involves buying more at the money or out of the money long term put options than the number of short term in the money put options are shorted.

Because In The Money (ITM) put options costs more than At The Money (ATM) or Out of the Money (OTM) put options, a lesser number of In The Money (ITM) put options is needed to cover the cost of the ATM or OTM options while still gaining in value slower than the combined number of ATM or OTM options when the underlying stock drops.

Put Diagonal Ratio Backspread Assuming QQQQ at $44. Buy To Open 2 QQQQ Feb44Put @ $1.55, Sell To Open 1 QQQQ Jan48Put @ $4.10 As the 2 Feb44Put costs $1.55 x 2 = $3.10, the 1 Jan48Put actually covers the entire price of the long put options and results in a net credit of $1.00.

The ratio of long and short put options depends largely on the preference of the individual trader. A common ratio is the 2 : 1 ratio spread where you sell to open 1 In The Money (ITM) put option for every 2 At The Money (ATM) or Out of the Money (OTM) put options that was bought.

What Strike Prices To Use In Put Diagonal Ratio Backspread?

The main deciding factor when determining what ratio to establish the Put Diagonal Ratio Backspread with is strike price. Here are the effects of different strike prices being used :

1. The wider the strike price difference between the short and long put options, the lesser In The Money (ITM) put options you would need to sell in order to cover the price of the long put options, the bigger the profit if the stock goes down but the further the upper breakeven point becomes, making it harder for the position to profit if the stock goes upwards instead.

2. The narrower the strike price difference between the short and long put options, the higher the potential downside profit and the nearer the upper breakeven point, but the lower the profit would be if the stock goes up instead due to a smaller net credit.

From the guidelines above, it is obvious that the higher we expect the net credit to be, the higher the stock needs to rally in order to profit to upside. This is the kind of compromise every options traders should be familar with in options trading. As such, we should always choose to sell the nearest in the money (ITM) put options which covers the total price of the long put options without exceeding the number of long put options bought.
Profit Potential of Put Diagonal Ratio Backspread :
The Put Diagonal Ratio Backspread has an unlimited profit potential to downside and will keep making more profit as long as the underlying stock keeps dropping. It also has limit profit potential to upside and will make the net credit as profit if the stock rallies above the upper breakeven point.

Profit Calculation of Put Diagonal Ratio Backspread:

Profit = (Profit on Long Puts) - (Loss on Short Puts)

Profit Calculation of Put Diagonal Ratio Backspread: Assuming QQQQ at $44. Buy To Open 2 QQQQ Feb44Put @ $1.55, Sell To Open 1 QQQQ Jan48Put @ $4.10. Assume QQQQ drops to $38 during January expiration, Feb44Put rises to $6.05 and Jan48Put rises to $10.00 Profit = (6.05 - 1.55) x 200 - (10.00 - 4.10) x 100 = 900 - 590 = $310 profit Because you paid nothing to put on this position, profit % is infinite. You made money out of nothing.

Maximum loss = Intrinsic Value of short put options - total credit recieved

Maximum Loss Calculation of Put Diagonal Ratio Backspread: Assuming QQQQ at $44. Buy To Open 2 QQQQ Feb44Put @ $1.55, Sell To Open 1 QQQQ Jan48Put @ $4.10. Maximum Loss = $400 - $100 = $300 when QQQQ closes at $44 upon expiration.

Risk / Reward of Put Diagonal Ratio Backspread:

Upside Maximum Profit: Unlimited

Maximum Loss: limited
Maximum loss occurs when the underlying stock closes exactly at the strike price of the Long put options.

Break Even Point of Put Diagonal Ratio Backspread:

There are 2 breakeven points for a Put Diagonal Ratio Backspread. The Lower Breakeven Point is point below which the position will start to make an unlimited profit. The Upper Breakeven Point is the point above which the position will make in profit the net credit received.

Lower Breakeven Point = long Put strike - (number of contracts sold x Difference Between Strike) + net credit

Profit Calculation of Put Diagonal Ratio Backspread: Assuming QQQQ at $44. Buy To Open 2 contracts of QQQQ Feb44Put @ $1.55, Sell To Open 1 contract of QQQQ Jan48Put @ $4.10. Net credit = $1.00 Lower Breakeven Point = 44 - (1 x 4) + 1 = $41.00

Upper Breakeven Point = strike price of short put - (net credit / contracts sold)

Profit Calculation of Put Diagonal Ratio Backspread: Continuing from the previous example: Upper Breakeven Point = 48 - (1.00 / 1) = $47.00

As you noticed from above, the Put Diagonal Ratio Backspread offers the best of both worlds as long as the underlying stock moves significantly up or down.

Advantages Of Put Diagonal Ratio Backspread :

Credit Spread, no upfront payment needed

Unlimited profit potential to downside and limit profit potential to upside

Disadvantages Of Put Diagonal Ratio Backspread :

Broker needs to allow the trading of credit spreads

Makes less profit than a long Put option strategy on the same drop in the underlying stock

Alternate Actions Before Expiration :

1. If the position is already in profit and the underlying stock is expected to continue falling, you could buy to close the short put options, transforming the position into a Long Put Option in order to maximise profits.

2. If the position is in profit and the underlying stock is expected to reach a certain price by expiration or stay stagnant at a certain lower price, one could buy to close the short put options and then sell to open put options at the strike price which the underlying stock is expected to fall to. This transforms the position into a Bear Put Spread.

3. If the underlying stock fails to move beyond either breakeven point by expiration of the near term put options, roll those short put options into the next further month. This is the advantage Put Ratio Backspread does not have.

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