It has to be an Options strategy that not only helps you be profitable when the market is going down…
But it also has to be a safe Options strategy that also helps you be profitable once the market recovers and is on the way up!
After all, the stock market in general wants to go up over time.
So we want to have an Options strategy that helps you be profitable on the way down and on the way up.
And that Options strategy is none other than the Put Ratio Spread.
The Put Ratio Spread is hands down the best Options strategy for a bear market.
That’s because the Put Ratio Spread is a fantastic way to get Long your favorite stocks at a deep discount!
Ready to find out how?
Let’s go!
What is a Put Ratio Spread?
By definition, the Put Ratio Spread is a neutral to bearish strategy that seeks to profit from a downward move in the market.
It is a combination of two Option strategies:
- Bear Put Spread
- Cash Secured Put
The Bear Put Spread (a.k.a. Debit Vertical Spread) is a debit spread.
That means we will have to pay for it.
The Cash Secured Put (a.k.a. Short Put), on the other hand, is a credit Options strategy.
And that means we will receive a credit for selling the Put Option.
The idea here is to use the credit we receive from selling the Cash Secured Put to finance the purchase of the Bear Put Spread.
If you take a look at the image above, you will see that the Bear Put Spread has a debit of $2.18.
And the Cash Secured Put has a credit of $2.44.
When combining these two, we get a net credit of $0.26.
Which is $26 into our pocket.
Now, you might be wondering why is the credit so little.
That’s because I created the Put Ratio Spread with a wide Bear Put Spread.
If you wanted a bigger credit for the Put Ratio Spread, you could reduce the width of the Bear Put Spread.
For example, instead of going with a 101/95 strike price for the Bear Put Spread, you could change it to 100/95, 99/95, or even 96/95.
This way the Bear Put Spread will have a smaller debit, which allows for the net credit on the Put Ratio Spread to be larger.
However, if you receive a larger credit for the Put Ratio Spread, it means the profit potential on the Bear Put Spread will be smaller.
So this is a trade-off between having a larger credit on the Put Ratio Spread with a smaller profit on the Bear Put Spread, versus a smaller credit on the Put Ratio Spread but with a larger profit on the Bear Put Spread.
Ultimately, it is up to you to decide which you prefer!
Put Ratio Spread Payoff Diagram
In the image above is the Put Ratio Spread payoff diagram.
If you look at the percentage at the top right-hand corner of the image, it shows “86.04%”.
This percentage represents the Probability of Profit.
That means this Put Ratio Spread has an 86.04 percent chance of being profitable!
That’s a huge profit zone!
And this is an Options strategy that allows you to profit regardless if the market goes up, down, or sideways.
As you can see from the payoff diagram, the profit can go as high as over $600 if the market closes right at the Short strikes at $95 (which is the strike price of the Cash Secured Put).
And if the market goes above $101 (the Long leg), you still get to keep the premium you received for selling the Put Ratio Spread, which is $26.
The part of the payoff diagram that’s highlighted in grey in the background is the 1 standard deviation move of the underlying stock.
That means that the majority of the time, the market would close between this grey area.
And the line at the left-hand side, just outside of the 1 standard deviation mark at $88.75, is the breakeven point.
And since the 1 standard deviation does not go below the breakeven point, that also means that there’s a low probability the underlying stock will go past the breakeven point at expiration.
In fact, there’s only a probability of 13.96 percent that the underlying stock would go below the breakeven point at expiration.
That means that the majority of the time, the Put Ratio Spread will be profitable!
So with the Put Ratio Spread, you can construct a very high Probability of Profit if you wanted to.
But what if you wanted to sell a Put Ratio Spread that receives a higher credit upfront?
Then you could construct a Put Ratio Spread like this:
If you see the payoff diagram above, you will notice that there’s a higher profit received for the Put Ratio Spread if the market went above $101.
That’s a profit of around $100.
This is roughly four times more than the previous Put Ratio Spread we constructed.
But if you see the payoff diagram carefully, you will also notice that there’s a trade-off.
Firstly, the Probability of Profit is slightly lower at 78.54 percent compared to the 86.04 percent of the other Put Ratio Spread.
Secondly, the Short leg strikes are no longer at $95, but at $97.
This results in a cheaper Bear Put Spread since the spread is now only $4 wide as opposed to the $6 wide Bear Put Spread in the previous payoff diagram.
That also means that you will make lesser if the market pins the Short strikes at $97.
You can see that if the underlying stock is at $97 at the Options’ expiration, the max profit is only about $500.
Whereas the max profit is $600+ in the previous Put Ratio Spread construct.
Finally, the breakeven point is at $91.52, which is higher than the breakeven point of the other Put Ratio Spread.
That means that the underlying stock does not have to drop as much for this Put Ratio Spread construct to start losing money.
So while you can collect a higher premium upfront by selling this Put Ratio Spread, there’s a trade-off in other aspects.
This is something you must be aware of when constructing your own Put Ratio Spread.
Put Ratio Spread VS. Cash Secured Put
Now, what if we compare this to the Cash Secured Put?
If we were to use the same strike price of $95 for the Cash Secured Put, you can see in the payoff diagram above that the profit zone is considerably smaller at 73.56 percent.
Furthermore, the breakeven point is significantly higher at $92.57 (compared to $88.75 with the Put Ratio Spread).
That means it’s easier for the underlying stock to breach the breakeven point in the Cash Secured Put than it is in the Put Ratio Spread.
And you only receive a fixed amount regardless if the market goes up or down.
For the Put Ratio Spread, you actually make more if the market goes down.
This way you’re “compensated” as the market drops.
In a bear market, the market wants to go down.
In the chart above, you can see that in a bear market, it forms lower lows and lower highs wave patterns.
The wave down is longer than the wave up.
So psychologically, it’s easier to sell the Put Ratio Spread than it is with the Cash Secured Put.
That’s because when you sell the Cash Secured Put, you want the market to go up so you can realize the profit on the credit you received.
But with the Put Ratio Spread, you want the market to go down so you can realize the max profit of the embedded Bear Put Spread.
So with these longer waves down, the Put Ratio Spread would be a better strategy.
That’s why I prefer the Put Ratio Spread in a bear market compared to the Cash Secured Put.
Long Stock VS. Put Ratio Spread
I love to use the Put Ratio Spread as a way to get Long stocks.
But you might ask:
Davis, if you want to Long stocks, why not just place a Buy Limit Order instead?
Good question!
So I want to illustrate the difference between the traditional way of buying stocks using a Buy Limit Order, and using the Put Ratio Spread to buy stocks.
Let’s say, for example, you wanted to buy Nike (Ticker: NKE) at $95.
Method 1: Place a Buy Limit Order for 100 shares at $95
If the market stays above $95, you don’t get filled.
You make no money as well.
If the market goes down to $95, you get filled 100 shares.
The cost for buying the 100 shares would be:
$95 x 100 shares = $95,000
Method 2: Sell a Put Ratio Spread with strikes 101/95 for $0.26.
If the market is above $101 at expiration, you still get to keep the $26 you received for selling the Put Ratio Spread.
If the market is in-between $101 and $95 at expiration, you get to make a profit from the Bear Put Spread component of the Put Ratio Spread, and also keep the $26 credit.
And if the market is below $95 at expiration, you get to make the full profit of the Bear Put Spread (which is $600), keep the $26 credit, and be Long 100 shares at $95.
The net cost for buying the 100 shares would be:
$95,000 – ($600 + $26) = $94,274
This makes the effective cost price of the stock $94.27 per share.
In all scenarios, the Put Ratio Spread is better than just placing a Buy Limit Order!
Put Ratio Spread Example
Here is an actual Put Ratio Spread I did on QQQs.
On 9th June 2022, I sold a Put Ratio Spread with the strikes of 300/291/290 expiring on 17 June 2022, for a credit of $0.07.
Basically, this consisted of:
- A Bear Put Spread with the strikes 300/291 ($4.66 debit)
- A Short Put with the strike price of 290 ($4.73 credit)
Overall, I received $7 in premium for selling this Put Ratio Spread.
On the expiration date of 17 June 2022, QQQs closed well below my Short Put strike price at 290.
The first thing I did was to close out the Bear Put Spread for a credit of $8.98, which is pretty much the max profit of $9.00.
After closing the Bear Put Spread, instead of letting the Short Put expire In-The-Money and getting assigned 100 shares at $290…
I decided instead to roll my Short Put Out to a further expiration date on 27 June 22 for a credit…
And subsequently used the credit to purchase another Bear Put Spread with the strike prices of 270/267 with the same expiration date.
By doing so, I was able to get a net credit of $0.08 for this.
Now I had a Short Put at the strike price of 290, and also a Bear Put Spread below my Short Put with the strikes of 270/267.
On the chart, it looked like this:
Now, you might be wondering why I did this instead of simply letting my Short Put get assigned, or just rolling my Short Put.
And the reason is that I thought QQQs might still go down a little bit more.
This way if QQQs did go down, I’d pocket another $300 from the Bear Put Spread.
Then I’d either let my Short Put get assigned, or just roll it again to receive more credit (depending on whether I could roll for a credit).
And if QQQs went up, I’d be able to either roll the Short Put for a nice credit…
Or, if QQQs went up above my strike price of 290, I’d be able to let the Short Put expire worthless and have the entire trade closed out to realize my profits.
To me, they are all win-win scenarios because I already didn’t mind owning 100 shares of QQQs at $290!
That’s because I’m confident that in the long run, QQQs will eventually go higher.
On the expiration date of 27 June 2022, QQQs closed above my Short Put strike price of 290 making my Short Put expire worthless.
While I wasn’t able to pocket the $300 on the Bear Put Spread, I was able to close out the whole entire trade and realize my profits.
The total profit for this trade was:
$7 + $898 + $8 = $913
And since this whole trade took 18 days, the Annualized ROI was:
$913 / $29,000 / 18 days x 365 days = 63.84%
If I hadn’t bought the Bear Put Spread after rolling my Short Put, I would have gotten more profits!
But I certainly didn’t regret buying that Bear Put Spread because QQQs could have very well gone lower then.
And if QQQs did go lower and I didn’t buy the Bear Put Spread then, I’d be kicking myself!
So now that you’ve seen how I have entered a Put Ratio Spread trade and also how I made adjustments on the Put Ratio Spread, will you start selling the Put Ratio Spread as well?
Let me know in the comments below!
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