Options Trading Made Easy: Put Diagonal Ratio Backspread

Despite its cumbersome name, the put diagonal ratio backspread is worth getting to know, as it offers the potential for two-way profits – as well as an initial credit.
Before we break it down, though, let’s look at how it’s composed.

Two Legs, Two Expiries

To begin, the strategy requires that you sell one at-the-money put with a near-month expiry. Following that, two out-of-the-money puts are purchased with a later expiry. The exact number of short and long options traded is, of course, a discretionary matter, but the strategy is generally implemented to produce a net credit.
The resulting profit/loss matrix of the spread is a rather complex affair (as it is with all diagonal calendar spreads). The number of variables are simply too broad to pin down precise break-even points. That said, it’s fair to approximate maximum gains and losses for the strategy with the following summary.
Gains: The trade produces its best results when the initial short put closes out of the money and the underlying falls steeply thereafter, placing the long puts deep in the money.
Losses: The worst-case scenario for the trade has the underlying dropping steeply at the outset, incurring a painful loss on the short put, only to rebound and close above the long put strike by the second expiry.
Traders who expect upcoming volatility (preferably a steep decline) – and are prepared to close out both legs of the trade simultaneously – will normally see the best results.

Case in Point: The Small-Cap Stumble

Here’s a real-life example to give you a better feel of how exactly to employ the put diagonal ratio backspread.

Above is a chart of the small-cap iShares Russell 2000 ETF (NYSEArca: IWM).
It’s the beginning of July, and your research suggests the small caps will shortly be trounced. You’d like to purchase puts on the index, but you’re worried about both the cost and the potential loss of premium should the trade go against you.
After some consideration, you decide to play it safe and institute a put diagonal ratio backspread.  That way the cost of the puts is covered, and even if there’s less profit potential, at least there will be something gained should the underlying move higher.
With IWM sitting at $125 you go into action (red circle). You sell one at-the-money August 125 put for $5.50 and buy two September 122 puts for $2 each. Total credit on the trade is $1.50.
Results!
Then, as you figured, IWM dumps – and fast. Within a few weeks, it has crossed below the long put strike for good, and by the first expiry it’s sitting at 115 (blue circle).
At that point, you have a choice either to close out the short put for a $1,000 debit and leave the long puts to ride (with the hope that they’ll decline further into the money); or, to close the entire trade now and take both the time and intrinsic value on offer from the two long puts (they’re trading at $9.80 each).
With just a few hours to go before the short put expires, you decide that prudence is best and close out all the options.  After all, you figure, the stock could easily bounce from here and leave you with nothing on the long leg.
You buy back the short put and sell the longs, and your profit is $1,110 ([$9.80 + $9.80 – $10 + $1.50] x 100), including the initial credit.
Note: Had the stock bumped higher and all options closed out of the money, you’d still be sitting on a $150 profit.

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