What is a back spread with puts?
A back spread with puts is a strategy that has three parts. You sell a put option that is in the money and two other put options that are out of the money. The long put options will have the same strike price. All three put options will expire on the same day.
There are two ways to open a back spread with puts: either for a debit or for a credit. However, the typical way to do it is for a credit.
A back spread with puts is when you sell-to-open (STO) one short put option that is in-the-money, and then you buy-to-open (BTO) two long put options that are out-of-the money below the short put option. This must have a ratio where more long puts are purchased than short puts are sold.
When to use a back spread with puts strategy
A back spread with puts is a suitable strategy for a trader who is bearish on an underlying asset and believes the price will be below a certain strike price by expiration. This strategy profits as the underlying asset falls in price, with no cap on how much the stock could decline.
How to manage a back spread with puts position
The impact of time decay on a back spread with puts depends on the underlying stock's price relative to the strike prices included in your trade, and whether or not you've set up the strategy for a net credit or debit.
If you have a net credit, time decay will reduce the value of your position if the stock is trading below the higher strike. This is because time decay will cause a loss value in your two long puts that exceeds the existing value of the short put.
Time decay is most harmful to your position when the stock is trading close to the lower strike price. That's when you'll lose the most money at expiration.
If the underlying stock is trading at or above the higher strike, then time decay will help your position. Ideally all of your options expire worthless so you can collect the credit you obtained when initiating the trade.
If you establish a net debit strategy, time decay will reduce the value of your position across all stock prices. This happens because the value of your two long puts will be eroded more than the value of the short put.
Back spread with puts maximum profit potential
In theory, when you trade a back spread with puts, you can make a lot of money if the stock goes to zero. But this is a rare event, so don't count on it happening.
Back spread with puts maximum loss potential
The risk on a back spread with puts is limited to the difference between the higher and lower strike prices, minus the amount of money you received in the form of a credit for entering the trade.