This column mainly examines some of the standard option trades, such as bull call spreads and covered calls. Today's edition looks at one of the less common option strategies: a put ratio backspread. It uses Advanced Micro Devices, or AMD stock, as an example.
A put backspread involves selling a put and then buying two further out-of-the-money puts. Traders use this strategy when they expect a large drop in a particular stock but hope to avoid losing money on a potential bounce.
The advantage of using a backspread is a much lower cost than simply buying a put option. The positive Vega, which measures an option's price sensitivity to changes in the asset's volatility, also helps generate profits in the event of a sell-off.
Assume a trader wants to protect against a big drop in Advanced Micro. A put ratio backspread will do well if AMD stock suffers a significant drop, and will not lose any money if shares stay flat or rally.
This type of trade could be perfect for this market. The risk on the trade is a small, slow decline in the stock price. So, if a decline is to happen, a hard and fast drop is best.
How The Put Ratio Backspread Works
Let's look at an example:
— Sell 1 May 16, 85-strike put at 3.30.
— Buy 2 May 16, 75-strike puts at 1.60.
The trade can be placed for a net credit of $10 calculated by taking the credit received for selling the 150 put, or $330, less the premium paid for the two 140 puts, or $320.
If AMD stock stays above 84 at expiration, the trader keeps the small amount of premium. The maximum loss occurs if AMD stock finishes at 75 on expiration day. In that case, the trader loses $990 on the trade.
Investors can calculate this by taking the difference between the short and long strikes times 100, or $1000. Then they subtract the premium received, or $10. The maximum gain is unlimited up to the point the stock reaches $0.
This is an advanced trading strategy and not recommended for beginners. The ideal scenario for the trade is a large drop — and associated rise in implied volatility — within the first two weeks. Otherwise, flat or higher prices are fine too.
Earnings Risk For AMD Stock
The company plans to announce results in early May, so this trade brings earnings risk if held until expiration.
According to the IBD Stock Checkup, AMD stock is ranked No. 10 in its group and has a Composite Rating of 55, an EPS Rating of 96 and a Relative Strength Rating of 14.
Please remember that options are risky, and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
