In this column, we've mainly looked at some of the standard option trades like bull put spreads and iron condors. Today, let's look at one of the less common option strategies, called a put ratio backspread. We'll use AMD stock to demonstrate.
The Put Ratio Backspread
A put backspread involves selling a put and then buying two further out-of-the-money puts. This strategy is used when a trader expects a large drop in a particular stock but doesn't want to lose money on a potential bounce. With Advanced Micro Devices down nearly 50% and it might not be done dropping.
A put ratio backspread will do well if AMD stock suffers a significant drop but it won't lose money if AMD stock stays flat or rallies. The risk on the trade is a small, slow decline in the stock price. If a decline is to happen, a hard and fast drop is best.
The advantage of using a backspread is a much lower cost than simply buying a put option. The positive Vega also helps generate profits in the event of a sell-off.
Setting Up The Option Trade On AMD Stock
Here's how to set up a put ratio backspread on AMD stock.
You sell a 75 put with a July 15 expiration on AMD stock, which traded around 4.70. For every contract sold, buy two puts with a 65 strike and the same expiration, trading around 2.25.
The trade receives a net credit of $20 for each backspread. That's calculated by taking the credit received for selling the 75 put ($470) less the premium paid for the two 65 puts ($450).
Profit And Loss
The maximum loss occurs if AMD stock finishes at 65 on expiration day. In that case, the trader loses $980 on the trade. Calculate this by taking the difference between the short and long strikes, multiplying by the 100 shares per contract and subtracting the premium received (10 X 100 — 20).
For the maximum gain, the ideal scenario is a large drop in AMD stock (and associated rise in implied volatility) within the first two weeks. The gain increases up to the point where the stock reaches $0. The two puts bought increase profits more than the loss of the one sold the more the stock drops.
Flat, or higher prices, are fine too. If AMD stock stays above 75 at expiration, the trader keeps the small amount of premium as the options expire worthless.
AMD stock announced earnings recently, so there should be no earnings risk with this trade.
This is an advanced trading strategy and not recommended for beginners.
According to the IBD Stock Checkup, AMD stock ranks No. 8 in its group and has a Composite Rating of 79, an EPS Rating of 99 and a Relative Strength Rating of 34.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
