The put ratio backspread is a relatively complicated option strategy that involves simultaneously buying and selling puts. The "ratio" part comes in because you buy more puts than you sell...the ratio of which determines the structure of the trade.
When you sell an options contract, you collect a premium, i.e. you get paid money in the deal. When you buy one, you have to pay out. Those details might sound a little basic, but they're crucial for explaining the way this setup works.
In setting up the put ratio backspread, you are selling puts in order to pay for other puts you want to buy. Usually, a trader will try to secure a slight gain from the initial buying and selling transactions, so that if all else fails, they will be sure of that small profit. However, trades often get set up with a mild deficit at the start, with the trader hoping to make it up by guessing correctly about the movement of the underlying asset.
Shares of Poot Limited are trading at $20. Puts with a strike price of $21 are trading at $2. Puts with a strike price of $19 are trading at $75. You sell one put with a strike price of $21, bringing yourself $2 in the transaction. Meanwhile, you buy two puts with the $19 strike price, for which you have to pay $0.75 for each. You've earned a premium of $2 from the sale, while the puts you bought cost you a total of $1.50. You're up $0.50 so far. (This is all multiplied by 100, because any option contract applies to 100 shares; your total gain on the deal so far is $50).
Now, if the stock falls below $19, the two puts you bought will pay off. If it doesn't drop, you've still got the small profit you secured from the initial transactions.
Related or Semi-related Video
Finance: What is the Advance Decline Rat...14 Views
Finance a la shmoop. What is the advance decline ratio? Alright people it's just a
percentage just like all its brethren or fellow ratios. Alright but what does that [Guy talking with his arms up]
percentage tell us what's that ratio all about? Well, basically looks at a given
index like the 500 stocks of the cleverly named S&P 500 or the 30 stocks [List of stocks]
of the Dow or the 1200 ish stocks of the Shmegeggie's small-cap index, yeah well then [Book of smallcap stocks]
just adds up which stocks went up that day like well last Tuesday 312 stocks in [Someone using a calculator]
the S&P 500 went up and 185 stocks went down and the rest just sat there not
moving, you know like this guy, a congressman, our finest, best and brightest. So why does this [Someone asleep in the audience]
advance decline number even matter? Like why do we track it, well what if we had
an index where technology stocks comprised like a third of the entire [Pie chart showing the large proportion of tech stocks]
index and you know the saying when Apple catches a cold the rest of tech is [Guy with an Apple briefcase for a head sneezes]
infected with Ebola. Yeah that's the same really, at least in Silicon Valley. All
right all right maybe you don't know that saying well it just means that
Apple is a really big market cap stock like knocking on the door of a trillion [Guy talking in front of an Apple store]
bucks, so it represents a huge percentage of the tech index. So when Apple stock
does poorly on a given day it tends to bring down all the other tech stocks in [Apple stock value going down]
its wake, why? Well because so many investors
assume that wherever Apple goes from an investor sentiment perspective that's [Guy answers the phone is shocked Apple is going down]
where all the other tech stocks will go as well Apple buys a gazillion
semiconductors and storage devices and stamping facilities so if it's business [Pictures of tech]
softens well then it's likely that the business of all the others in that tech
ecosystem who feed into it well they soften as well because Apple
is such a big customer in that space. So if Apple and tech dropped 20% in a given
day and all of tech goes down like a meaningful amount and that index is a [Down arrow on the stock index]
third tech well the rest of the market banks, transportation, mining, agriculture [Pictures of the industries]
etc well they might have had just a fine day they might have been up. But if tech
which is a third of that index is all down 20% on that one
day well the overall index would show that well the whole markets down an ugly [Guy showing the market price is down]
six plus percent and all you would have seen as an investor that the blah blah
blah 500 index fell from eight thousand seventy four hundred today, well you [Stock value chart going down]
might think the world was ending when in fact it was only the tech world that [A globe is shot]
ended that day, not everything else like banks might have had a great day, who [Grave stone for tech]
knows all the rest of the stocks that day might have gone up a little bit in
which case two-thirds of the stocks would have advanced and yeah, tech which [Arrow pointing to the other stocks which have increased in value]
was a third of them would have declined and you'd say that the advanced decline
ratio on that day was two to one. So if you were savvy you'd think it really odd
to have an advanced decline ratio at 200% i.e. well above one in a market that
was down a massive six percent that day something would not be adding up in your [Guy in a suit on the phone]
brain and you know to not just trust the index number you actually heard on the
news to reflect what actually happened with market conditions that day right so [Woman on the news showing stock price plummeting]
that's why you take a very hard look at the advanced decline ratio that's kind
of a delimiter or truing algorithm in all this.
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