Short Bear Ratio Spread

How Does Short Bear Ratio Spread Work in Options Trading?

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Short Bear Ratio Spread - Introduction

A Short Bear Ratio Spread, or sometimes known as a Short Ratio Bear Spread, a Short Put Ratio Spread or a Short Ratio Put Spread or a Put Back Spread, is a cousin of the Bear Ratio Spread. It is a bearish put option strategy which not only eliminates upfront payment, but also allows an unlimited profit potential, something which the Bear Ratio Spread is unable to achieve.

The Short Bear Ratio Spread is made up of buying At The Money (ATM) or slightly Out Of The Money (OTM) put options and then selling to open a lesser number of In The Money (ITM), more expensive put options of the same expiration month.

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Because In The Money (ITM) put options costs more than At The Money (ATM) or Out of the Money (OTM) put options, a lesser number of In The Money (ITM) put options is needed to cover or significantly reduce the cost of the ATM or OTM options while still gaining in value slower than the combined number of ATM or OTM options when the underlying stock falls.

Short Bear Ratio Spread Example Assuming QQQQ at $44. Buy To Open 3 QQQQ Jan44Put @ $1.05, Sell To Open 1 QQQQ Jan47Put@ $3.15 As the 3 Jan44Put costs $1.05 x 3 = $3.15, the 1 Jan47Put actually covers the entire price of the long Put Options resulting in a zero upfront payment.

The ratio of long and short put options depends largely on the preference of the individual trader. A common ratio is the 3 : 1 ratio spread where you sell to open 1 In The Money (ITM) put option for every 3 At The Money (ATM) or Out of the Money (OTM) put options that was bought.

What Strike Prices To Use In Short Bear Ratio Spread?

The main deciding factor when determining what ratio to establish the Short Bear Ratio Spread with is strike price. Here are the effects of different strike prices being used :

1. The wider the strike price difference between the short and Long Put Options, the less In The Money (ITM) put options you would need to sell in order to cover the price of the Long Put Options but the further the lower breakeven point becomes.

2. The narrower the strike price difference between the short and Long Put Options, the higher the potential profit and the nearer the lower breakeven point.

3. If the short put options costs more than the Long Put Options, a net credit results which allows the position to make a profit if the underlying stock falls drastically. This transforms a Short Bear Ratio Spread into a volatile option strategy instead of a bearish option strategy.

4. If the number of In The Money (ITM) short put options is equal to or exceeds the number of Long Put Options, the position will lose money when the underlying stock goes up, essentially eliminating it's effectiveness as a bearish option strategy.

From the guidelines above, it is obvious that we should always choose to sell the nearest in the money (ITM) put options which covers the total price of the Long Put Options without exceeding the number of Long Put Options bought.

When To Use Short Bear Ratio Spread?

One should use a Short Bear Ratio Spread when one is confident in a strong fall in the underlying instrument and wishes to profit from that fall without any upfront payment and not lose any money should the stock rises .

Profit Potential of Short Bear Ratio Spread :

The Short Bear Ratio Spread has an unlimited profit potential. It will keep making more profit as long as the underlying stock keep falling. The profitability of a short bear ratio spread can also be enhanced or better guaranteed by legging into the position properly.

Trading Level Required For Short Bear Ratio Spread

A Level 3 options trading account that allows the execution of debit spreads is needed for the Short Bear Ratio Spread. Read more about Options Account Trading Levels.

Profit Calculation of Short Bear Ratio Spread:

Profit = ((long put strike - stock price) x number of Long Put Options) - ((short put strike - stock price) x number of short put options)

Profit Calculation of Short Bear Ratio Spread Assuming QQQQ at $44. Buy To Open 3 QQQQ Jan44Put @ $1.05, Sell To Open 1 QQQQ Jan47Put@ $3.15. Assume QQQQ falls to $41. Profit = ((44 - 41) x 300) - (((47 - 41) x 100) = 900 - 600 = $300 profit. Because you paid nothing to put on this position, profit % is infinite. You made money out of nothing.

Maximum loss = Total Premium Value Of Long Put Options - Total Premium Value Of Short put options

Profit Calculation of Short Bear Ratio Spread Assuming QQQQ at $44. Buy To Open 3 QQQQ Jan44Put @ $1.05, Sell To Open 1 QQQQ Jan47Put@ $3.15. Maximum Loss = ($1.05 x 300) - (($3.15 - $3) x 100) = $315 - $15 = $300 when QQQQ closes at $44 upon expiration.

Risk / Reward of Short Bear Ratio Spread:

Upside Maximum Profit: Unlimited

Maximum Loss: limited
Maximum loss occurs when the underlying stock closes exactly at the strike price of the Long Put Options.

Break Even Point of Short Bear Ratio Spread:

There are 2 breakeven points for a Short Bear Ratio Spread. The Lower Breakeven Point is point below which the position will start to make a profit. The Upper Breakeven Point is the point above which the position will lose only the net debit (if any).

Lower Breakeven Point = Strike Price Of Long Put Options - (Maximum loss / (number of Long Put Options - number of short put options))

Profit Calculation of Short Bear Ratio Spread Assuming QQQQ at $44. Buy To Open 3 QQQQ Jan44Put @ $1.05, Sell To Open 1 QQQQ Jan47Put@ $3.15. Net debit = 0, Maximum Loss = $300 Lower Breakeven Point = 44 - (300 / (300 - 100)) = 44 - 1.5 = $42.50

Upper Breakeven Point = Strike Price Of the Short put options.

Profit Calculation of Short Bear Ratio Spread Assuming QQQQ at $44. Buy To Open 3 QQQQ Jan44Put @ $1.05, Sell To Open 1 QQQQ Jan47Put@ $3.15. Net debit = 0 Upper Breakeven Point = $47 If the stock rises above $47, the position will expire with zero profit / loss.

As you noticed from above, the Short Bear Ratio Spread offers the best of both worlds as long as the underlying stock moves significantly up or down.

Advantages Of Short Bear Ratio Spread :

:: No upfront payment needed for the position.

:: No loss occurs if the underlying stock rises drastically instead of falls.

:: Unlimited profit potential

Disadvantages Of Short Bear Ratio Spread :

:: Broker needs to allow the trading of credit spreads.

:: Makes less profit than a Long Put Option strategy on the same move in the underlying stock.

Adjustments for Short Bear Ratio Spread Before Expiration :

1. If the position is already in profit and the underlying stock is expected to continue it's drop, one could buy to close the short put options, transforming the position into a Long Put Option in order to maximise profits.

2. If the position is in profit and the underlying stock is expected to reach a certain price by expiration or stay stagnant at a certain lower price, one could buy to close the short put options and then sell to open put options at the strike price which the underlying stock is expected to drop to. This transforms the position into a Bear Put Spread.

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