Put Back Spread
The put back spread is a good strategy when you are anticipating a significant drop in a volatile stock. To create a put back spread, you will need to sell a put at higher strike and then you will buy puts at lower strike price. This is best done with small credit so that you will not lose much if the stock remains the same or surges.
If the price of the stock drops as you anticipate, you will gain a lot because you have less short puts than long puts. For a maximum profit, you should use the in-the-money options since it is more likely to be in-the-money.
For example, you can create a put back spread if ABC is trading at $60. You can buy two 60 puts at $2.50 and sell one 65 put at $5.40. Here you can receive $40 for the trade. If the stock rises to more than 60, you will get the $40. However, you can make a lot of money if the price of the stock drops significantly. The downside breakeven is $55. Here the 60 puts will now be worth $5 and the 55 put will be $10. If the price of the stock falls below $55, you will lose significantly.
|ABC trading @ $60|
|Buy 2 60 Puts @ $2.50||$500.00|
|Sell 1 65 Put @ $13.50||($540.00)|
|Credit from Trade||($40.00)|
|Option Requirements to Maintain Position||$500.00|
The above example does not include the commission, tax and interest.
You can compute for the downside breakeven. Here is the formula:
Downside Breakeven = Long strike price – [(Long strike – short strike) x # of short contracts] + net credit/100 (or – net debit)
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