Higher Implied Volatility and Put Ratio Back Spread

The strategy has been a spread but not a combination with limited loss potential to the extent of exposure on short side but unlimited profit potential on long side. The degree of profit relies on the strength and rapidity of price movement. So far we all know that the position uses long and short puts in the ratio, such as 2:1 or 3:2 and so on to maximize returns depending upon risk appetite and returns expectations. In most long/short spreads, you make money if the underlying price moves, but you lose if it remains in the middle "loss zone." A ratio put back spread is different because it creates a net credit, so even if the underlying price does not move very much, you keep the credit if all of the puts expire worthless.

Entering into this position in case of higher implied volatility and expecting for the inevitable adjustment is a smart approach, regardless of the direction of price movement. Based on volatility and time decay, the strategy is a "price neutral" approach to options, and one that makes a lot of sense.

Traders tend to view the put ratio back spread as a bear strategy, because it employs puts. However, it is actually a volatility strategy.Typically the position combines buying at-the-money or out-of-the-money puts and, at the same time, selling a smaller number of in-the-money puts. Those in-the-money puts are always at risk of exercise, but you have two advantages. The assignment can be covered by the long puts; second, time decay and implied volatility work in your favor on the short puts. This points out the importance of entering the position when implied volatility is higher than average.

The short position puts (which are in the money) will yield more premium income than the cost of the higher number of at- of out-of-the-money long positions. The ratio itself should vary depending on your belief in the strength, direction and timing of price movement, and also on the cost for each side. Creating a net credit is always desirable, so this also affects how many short and long puts you open.

The position is a complicated one, even for experienced options traders. Thus, it makes sense to experiment with varying levels of strikes and ratios. Paper-trade the put ratio backspread to experience how profits or limited losses develop, and how time to expiration affects both implied volatility adjustments and premium levels.