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Our previous entry in this options trading series dealt with the tremendous earnings potential of the call backspread strategy, employed when one expects a thunderously bullish move in a stock.
Today, we examine the same strategy when one expects the opposite.
The “put backspread” has two essential ingredients that combine to make it a great breadwinner when a security is poised to fall dramatically:
- A short at-the-money or slightly in-the-money put, and
- Two long out-of-the-money puts
The short put is initiated as a means of paying for the two long puts.
How the Put Backspread Works
Very simply, as the underlying stock craters, the short put creates a loss for the trader. But if the stock’s losses continue to mount, the two long puts swiftly ride to the rescue, creating a net profit as they sink deep into the money and “double team” the short put.
The below chart of the SPDR Gold Shares (NYSEArca: GLD), a sound proxy for gold bullion, clearly illustrates the strategy. The chart shows the GLD fund from January’s 52-week highs through the lows of August. Had a trader been bearish on the stock in January or February, a put backspread would have been an excellent strategy to initiate.
In this example, the trader sells the slightly in-the-money GLD July 123 put for $9.80 and purchases two out-of-the-money GLD July 117 puts for $4.60 each. The trade is launched on Feb. 1 (red circle) for a net credit of $0.60, and our wise trader waits.
By mid-March, GLD has gapped well below the long puts’ strike of 117, settling at the trade’s break-even point of 111 (blue circle) – the point at which the short put is in the money $12 and the long puts are in the money $6 each.
After considering closing out the trade at even money, our wise trader thinks better and opts for patience, as the trade’s expiration remains a full four months away.
Was That Wise?
Hindsight, of course, is 20/20, and a number of things could have gone wrong.
First, had gold bounced back above the short put strike at $123, all the options would have expired worthless, and our trader’s haul would have been limited to his initial credit of $60. Not bad, but no great showing.
The worst-case scenario would have occurred if the stock climbed back to $117 – the precise level of the two long puts – and expired there. At that point, the short put would have been $6.00 in the money, resulting in a $540 net loss ($6.00 – $0.60 [the trade’s initial credit] x 100). Remember that one options contract equals 100 shares.
As it turns out, the stock did bounce, but subsequently resumed its nosedive through the summer months, expiring at $104.20 (green circle) and offering our patient trader a full $760 for his restraint.
Here’s the breakdown:
- Long puts expire in the money at $12.80 each = $25.60
- Short put expires in the money $18.80
- Initial credit: $0.60
- Profit: ([25.60 – 18.80 + 0.60] x 100) = $760
See? Math can be fun.
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