Using a Back Spread to Profit from Big Declines
By: Steve Smith
This option strategy will keep you in the black when markets turn red.
Stocks sold off sharply last Friday but volatility levels as measured by the VIX remain near relatively low levels. The seeming lack of fear may be explained by the facts that the indices remain near all-time highs and that for the past few years dips were made to be bought.
I’m not trying to call a top or predict a decline. Which is one of the reasons I don’t want to go spend a lot of money on put options and watch that premium waste away if the market turns back higher.
That’s why I’m employing a strategy called a back spread, or sometimes referred to as a ratio-back spread.
More for Less
A back spread consists of all calls or all puts with the same expiration in which one sells a closer-to-the-money strike and buys a multiple number of contracts in a further out-of-the-money strike. The goal is to have as minimal an outlay or debit as possible while achieving the highest ratio of long option contracts to short.
The goal of a back spread is to buy as many options as possible relative to the number sold for the lowest cost. A good rule of thumb would be to buy 3 contracts for every 1 sold for even money. Of course, width between strike prices is one the determining factors of what ratio can be accomplished.
Not to get to wonky but being “net long” the number of contracts you own will translate into giving the position a positive gamma. This means delta increases as price moves in your direction. To put it simply; a bullish position gets longer or more bullish as price rises. A bearish back spread gets shorter or more bearish as price declines.
Another feature of the back spread is that it benefits from the increase in implied volatility that typically accompanies a sharp decline. This is why I tend to like to this strategy on puts during periods of relatively low volatility levels.
SPYing a Back Spread
With the SPDR 500 (SPY) currently trading at $208 there is major support near the 50 dma at the $206 level. If that fails we could quickly see a drop towards $200 or lower.
With those levels in mind I want to sell the $206 put and buy the $200 put. I want to give the position a few weeks which will balance seeing if the market recovers with a tight enough time frame to allow for a good ratio as a relatively low cost. Also, keeping the expiration less than 30 days will allow time decay to take hold and erode the $206 puts we’ve sold short at an accelerated rate. I’m focusing on the MarchQ1 options that expire on March 31st
Sell 1 MarchQ1 $206 puts at $2.50 a contract
Buy 3 MarchQ1 $200 puts at $0.90 a contract
This is a $0.20 net debit for the 1×3 back spread.
This $20 per 1×3 get you “net long” two of the $200 puts as a fraction of the cost of purchasing them outright which would have been $180.
If shares of SPY are above $206 on the March 31st expiration the loss is limited to just that $20 per 1×3 contract position.
But if the SPY starts tumbling the position’s value will expand dramatically providing potentially unlimited profits. For example, if SPY were to drop even to $202 by next week the back spread would be worth approximately $1.50 or a more than a six fold increase. Profits would increase as SPY price declines.
The Dead Zone
The drawback is that there’s a moderate decline that could lead to some steep losses. That is if SPY only drifts lower and is at $202 on the expiration that would leave the $206 put we are short $4 in-the-the-money and the $200 put we own near worthless. Meaning our back spread would be a $4 debit or $3.80 loss.
Two ways to avoid ending up in this dead zone are:
Close out the position at least a week prior to expiration if shares are near or below the short strike.
If the stock moves opposite your prediction, as in higher in this case, buy to close the short put. Remain long the out-of-the-money strikes at a discounted affective cost basis. Many times these seemingly worthless options can come back to life and produce big profits.
Back spreads are powerful positions but they must be used judicially and traded around nimbly.