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A Bold Strategy For Bearish Options Traders

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Most traders are familiar with basic bearish strategies, such as short selling and put buying. However, one slightly more complex way to bet against a stock or exchange-traded fund (ETF) -- especially for the trader who's confident in the underlying's trajectory  -- is with a put ratio spread.

As stated above, a put ratio spread is more complex than a straight long put or bear put spread. To initiate the most basic form of this strategy (i.e., the 2:1 ratio spread), a trader buys to open one put for stock XYZ and simultaneously sells to open two puts for the same underlying, but at a lower strike. Ultimately, the goal is for the stock to land exactly at the lower strike by the expiration date, maximizing the profit on the long put while allowing the short puts to expire worthless.

As with any options trading strategy, put ratio spreads have advantages and drawbacks. The main advantage is the lower cost of entry compared to a "vanilla" put purchase or long put spread, as the double short puts help to offset the cost of the long put. However, the main disadvantage is there are two ways to lose money: if the stock doesn't drop at all/far enough, or if the stock drops too far within the options' lifetime. After all, on a standard 2:1 put ratio spread, only one of the sold puts is covered, leaving the other short put "naked."

Perhaps a real-life example will make this easier to understand. Earlier this week, a trader initiated a put ratio spread on the iShares Russell 2000 Index ETF. Specifically, he bought to open 20,000 January 2017 118-strike puts for $4.75 apiece, for a total cost of $9.5 million (premium paid * number of contracts * 100 shares per contract). At the same time, the speculator sold to open 40,000 -- twice as many -- January 2017 106-strike puts for $1.90 apiece, collecting a total of $7.6 million. The difference between the premium paid and the premium received -- $0.95 per spread ($4.75 - [$1.90 x 2]), or $1.9 million total ($0.95 x 100 shares x 20,000 contracts) -- is the trader's cost of entry, offset heavily by the sold puts.

As stated above, the goal for this trader is for IWM to fall to $106 by January 2017 expiration -- a roughly 13% drop from current levels. If that happens, his profit would be the difference between the strikes ($12), less the initial net debit ($0.95 per spread), or $11.05 per spread -- $22.1 million ($11.05 x 100 shares per contract x 20,000 contracts). However, with each step south of $106, losses on the unhedged short put will begin eating into those profits until the trade ultimately moves into the red at $94.95 (lower strike less maximum potential profit).

Of course, the above scenario assumes the IWM trader is speculative. According to Trade-Alert, though -- given the deep out-of-the-money nature of the lower strike -- the options player may have initiated the put ratio spread as a hedge against a sharp downside move on the Russell 2000 Index.

Visit SchaeffersResearch.com to discover how you can use stock options to complement your investing portfolio.