Last week we looked at an advanced option strategy called a broken wing butterfly in new IPO Upstart (UPST). Today, we are going to look at a put ratio backspread. And we’ll focus on a trade with Merck (MRK), a stock in the Dow Jones Industrial Average.
A put backspread involves selling a put and then buying two further out-of-the-money puts. Traders use this strategy when they are expecting a large drop in a particular stock.
The advantage of using a backspread? A much lower cost than simply buying a put option.
The positive Vega also helps generate profits in the event of a sell-off.
Merck, currently trading near 73, shows a 6.5% loss year to date vs. a 13%-plus gain by the Dow industrials. A 22 Relative Strength Rating means MRK has outperformed only 22% of all companies in the IBD database over the past 12 months. MRK stock also has a Composite Rating of 58 and a dull EPS Rating of 69.
Merck Stock: Setting Up The Put Backspread
Assume a trader wants to protect against a big drop in Merck.
A put ratio backspread will do well if Merck stock suffers a significant drop and will not lose any money if MRK stays flat or rallies.
The risk on the trade is a small, slow decline in the stock price. If a decline is to happen, a hard and fast drop is best.
Let’s look at an example:
- Sell 1 Dec. 17 expiring 70-strike put at 2.40.
- Buy 2 Dec. 17, 65-strike puts at 1.10.
The trade can be placed for a net credit of $20 calculated by taking the credit received for selling the 70 put ($240) less the premium paid for the two 65 puts ($220).
Risk Vs. Reward
If Merck stays above 70 at expiration, the trader keeps the small amount of premium.
The maximum loss occurs if Merck stock finishes at 65 on expiration day, in which case the trader would lose $480 on the trade.
To calculate this, take the difference between the short and long strikes x 100 ($500) and subtract the premium received ($20). The maximum gain is unlimited up to the point the stock reaches $0. The break-even prices are 60.20 and 69.80.
This is an advanced trading strategy and not recommended for beginners.
The ideal scenario for the trade is a large drop (and an associated rise in implied volatility) within the first two weeks. Otherwise, flat or higher prices are fine too.
Merck earnings are set for late October.
Please remember that options are risky, and investors can lose 100% of their investment.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ.
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