The trade itself involves selling a put at a higher strike and buying a greater number of puts at a lower strike price.
Ideally, this trade will be initiated for a minimal debit or possibly a small credit. This way, if the stock gains ground, you won't suffer much either way. On the other hand, if the stock drops as you hope, the profit potential will be significant because you have more long than short puts. To maximize the potential for this position, many traders use in-the-money options because they have a higher likelihood of finishing in-the-money.
Using Intel (INTC), we can create a put backspread using in-the-money options. With INTC Trading at $30 in April, you might buy two of the May 30 puts at $1.25 and sell one May 32.5 put at $2.70.
In this example, you would receive $20 for putting on the trade. If the stock jumped above 30, you would profit $20. However, the real money would be made if the stock made a big move to the downside. The downside breakeven for this trade would be 27.50. At this price, the 30 puts would be worth $2.50 while the 32.5 puts would be worth $5. Below $27.50 the profit potential increases dramatically.
|INTC trading @ $30.06|
|Buy 2 MAY 30 Puts @ $1.25||$250.00|
|Sell 1 MAY 32.5 Put @ $2.70||($270.00)|
|Credit from Trade||($20.00)|
|Option Requirements to Maintain Position||$250.00|
*The profit/loss above does not factor in commissions, interest, or tax considerations.
Calculating the Breakeven
The easiest way to calculate the downside breakeven is by using the following formula:
Downside Breakeven = Long strike price - [(Long strike - short strike) * # of short contracts] + net credit/100 (or - net debit)
Using the data for this example, the breakeven calculation looks like this:
30 - [(30-32.5) * 1] - 20/100
Simplified, the equation becomes:
30 - [(2.30)] = 27.70