The difference in strike price between the written and the purchased options plus paid/minus received net premium.
Maximum loss:
Only limited by the fact that a stock or index level cannot drop below zero.
Realization of profit or loss:
The position is usually closed before the expiry day.
Margin requirements:
The position normally implies relatively limited margin requirements.
Market view
Establishing a negative back spread is a suitable strategy when you believe in a relatively large decline in a stock or an index until a certain date.
Construction
You establish a negative back spread by writing put options at a higher strike price and at the same time buying twice as many put options at a lower strike price. An advantage with establishing a negative price spread is that you have a much larger profit potential. On the other hand you will have a higher break-even point. An advantage compared to just buying put options is that you have a smaller cost of capital to establish the position. But instead you will have a higher break-even and will imply margin requirements.
Example: It is the 20th of August and stock A has a value of 300 crowns. The stock has risen 40 percent since New Year with support from a strong stock market and continuous structure trades within the industry. Your judgment however, says that the market players have overreacted a little and that there is a substantial risk for declining levels during the autumn. You think that the odds are good that stock A will drop at least 10 to 20 percent, corresponding to a level of 270-240, until the expiry day on the third Friday in October.
Since your experience says that it is hard to bet against a strongly rising trend you think it is too expensive to buy naked put options, and you decide to establish a negative back spread at a very low cost. You choose to write 10 put option contracts with strike price 300 at a cost of 2,000 crowns per contract and at the same time buy twice as many put option contracts with strike price 290 at a cost of 1,400 crowns per contract. This gives you a net cost of (10 x 2,000) – (20 x 1,400) = 8,000 crowns.
Results on the expiration day
The table below shows you the results for different share prices at expiration.
Stock price on the expiration day
Value 10 written Oct 300 put options
Value 20 purchased Oct 290 put options
Net premium paid
Total result
310
0
0
-8,000
-8,000
300
0
0
-8,000
-8,000
290
-10,000
0
-8,000
-18,000
280
-20,000
20,000
-8,000
-8,000
272
-28,000
36,000
-8,000
0
270
-30,000
40,000
-8,000
2,000
260
-40,000
60,000
-8,000
12,000
250
-50,000
80,000
-8,000
22,000
240
-60,000
100,000
-8,000
32,000
Profit, loss and break-even
The maximum profit from the above position is only limited by the fact that a stock price can never be negative. Due to the strategy’s low net cost your risk of loss is limited to 8,000 crowns if stock A, contrary to your opinion, rises from the existing level of 300 crowns.
Your maximum loss arises at a closing level of exactly 290. It is calculated as the difference in strike price between your written put options with a strike price of 290 multiplied by 1,000, plus the net premium of 8,000 that you paid. 18,000 crowns in total. Your break-even for the position is at a decline to 272 crowns. If instead, you had bought put options only, at a strike price of 300 for 2,000 crowns per contract, your break-even would have already been at 280 crowns.
Realization of profit
The negative back spread strategy has the advantage that you often, having a correct market opinion, can realize the profit before the expiry day. The reason for this is that the more the stock value declines, the more in-the-money the written options will be, and the less time value they will therefore contain. The purchased options will, with a correct market opinion, be closer to pari than the written options and therefore contain more time value.
Follow-up and protection
The same applies for the negative back spread as for the other strategies, that despite you being able to receive very high returns on invested capital; you can with a large probability minimize potential losses if you are wrong in your market opinion.
If you notice that stock A, contrary to your market opinion, starts to rise or lies still, you have several different possible ways to act depending on your new market opinion and risk aversion, for example:
If you believe that stock A will continue to rise, or at least not fall below 300, you can sell half, or all of, your purchased put options with strike price 290. If you choose to sell all of your purchased put options and the market begins to fall, your theoretical risk of loss will only be limited by the fact that a stock price can never turn negative. One way to protect yourself from such a scenario is either to buy back the written options or to sell an equal amount of stock futures as you have written stock options. Please observe that during a very fast decline it can be difficult to effectively manage the protection of the naked written put options. In addition you risk making a loss on the futures if the market should turn up again.
If the stock value has risen, but you still believe in a strong decline before the expiry day, you can lift the back spread. For example you can sell your purchased put options with a strike price of 290, and buy back your written put options at a strike price of 300 as well as buy another 20 put option contracts at a strike price of 300. Finally, you write 10 put option contracts at a strike price of 300. You will thereafter have a position consisting of 10 written put options at a strike price of 310 and 20 purchased put options at a strike price of 300.
Advantages with a negative back spread
Very large profit potential
Lower cost of capital than only buying put options
Good possibilities to avoid a larger loss having had an incorrect market opinion
Drawbacks with negative back spread
Implies margin requirements
Substantial movements are needed to reach break-even
Relatively high transaction costs due to many “option legs”
Choice of strike prices
Which strike prices to choose depends on how many percent you think that an index or a single stock will drop, and how risk avert you are. When you establish a negative back spread, the more capital you are willing to invest the higher the probability is that the position will result in a profitable outcome, and then less movements are needed to reach break-even. On the other hand, you can therefore risk losing a larger amount of capital if the stock price, contrary to your opinion, would rise.
As an example we can compare the position in our example above with you instead establishing a negative back spread by writing 10 put option contracts with a strike price of 300 at an income of 2,000 crowns per contract and at the same time buying twice as many put option contracts at strike price 280 at a cost of 1,000 crowns per contract. In this case it costs nothing to establish the position, but a decline all the way down to 260 crowns is needed before you begin to profit from the position. Your maximum loss now amounts to 20,000 crowns, and occurs exactly at the 280 crowns level. At a closing level of 300 crowns or above on the expiry day you will break-even.
