Put Back Spread
Risk: low
Reward: moderate
General Description
Entering a put back spread typically entails selling a put at a higher strike price and buying a greater number of puts at a lower strike price.
The Thinking
This strategy is employed when a big down moved is expected in a volatile stock but you want to lower your risk. You buy puts because you are bearish, but then you sell a higher strike price put to lower your risk. This lowers your max loss in place at a lower price. The drawback comes in the stock collapses. One of your long puts will be canceled out by your short put, so you profit potential is lowered.
Example
Let's say INTC is trading @ 30.06 and you think the stock will drop. Buy (2) 30 puts for 1.25 and then sell (1) 32.5 put for 2.70. Your net credit from initiating the trade is 0.20.
If the stock closes above 32.5, all puts will expire worthless and you keep the $20. Your greatest loss is $230 and occurs at 30. This is where the long 30 puts will expire worthless (a $250 loss) and your 32.5 put will be worth $20 (sold it for 2.7 and bought it back 2.5). Below 30 you will start getting some of your money back and below 27.7 your profit increases to a max when the stock drops to zero. But you will only make money on one of the long puts because the other one will be canceled out by your short put.
The image below summarizes the trade with a P/L Diagram. |
