Change text size

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

This is the sixth installment fin our series of articles covering a put ratio backspread. The idea of Real-World Trading is to provide readers with a real world scenario that is tracked from week to week to show how a particular strategy works. These articles aren't written to provide a trading opportunity, but rather a teaching opportunity. We try to explain the details of a particular strategy and by using a mock trade, we can see how week to week fluctuations in the price of the underlying impact the strategy.

In review, we are following the movement of the Nasdaq 100 Trust (QQQQ) using a put ratio backspread. This particular strategy is bested used when we expect a decline in the underlying, but want to be protected in case gains continue. When we entered this trade, the Qs were trading at $34.78 and had gained nearly 35 percent from its March lows. Nonetheless, the Qs have continued their ascent, though we are seeing some weakness seep into the shares. During this past week, the Qs moved slightly higher after falling 1.7 percent in the prior week, though the security is still above our beginning price.

Below is the week to week data for this trade:

May 26, 2009
QQQQ @ 34.78
Buy 2 Aug09 38 Puts @ 3.89 (IV=26.7)
Sell 1 Aug09 43 Put @ 8.30 (IV=28.6)
Credit to Enter = $52.00
Downside Breakeven = 33.52
Upside Breakeven = 42.48
Max Risk = $448.00

May 29, 2009
QQQQ @ 35.38
Long 2 Aug09 38 Puts @ 3.40 (IV=26.1)
Short 1 Aug09 43 Put @ 7.69 (IV=26.4)
Current Profit/Loss = $-37.00
Credit to Enter = $52.00
Downside Breakeven = 33.52
Upside Breakeven = 42.48
Max Risk = $448.00

June 5, 2009
QQQQ @ 36.78
Long 2 Aug09 38 Puts @ 2.56 (IV=28.1)
Short 1 Aug09 43 Put @ 6.37 (IV=25.7)
Current Profit/Loss = $-72.00
Credit to Enter = $52.00
Downside Breakeven = 33.52
Upside Breakeven = 42.48
Max Risk = $448.00

June 12, 2009
QQQQ @ 36.65
Long 2 Aug09 38 Puts @ 2.50 (IV=27.2)
Short 1 Aug09 43 Put @ 6.50 (IV=27.4)
Current Profit/Loss = $-97.00
Credit to Enter = $52.00
Downside Breakeven = 33.52
Upside Breakeven = 42.48
Max Risk = $448.00

June 19, 2009
QQQQ @ 36.16
Long 2 Aug09 38 Puts @ 2.65 (IV=25.8)
Short 1 Aug09 43 Put @ 6.93 (IV=28.0)
Current Profit/Loss = $-111.00
Credit to Enter = $52.00
Downside Breakeven = 33.52
Upside Breakeven = 42.48
Max Risk = $448.00

June 26, 2009
QQQQ @ 36.37
Long 2 Aug09 38 Puts @ 2.34 (IV=24.0)
Short 1 Aug09 43 Put @ 6.68 (IV=26.8)
Current Profit/Loss = $-148.00
Credit to Enter = $52.00
Downside Breakeven = 33.52
Upside Breakeven = 42.48
Max Risk = $448.00

Here is the risk graph and data for this particular trade:

Figure 1: QQQQ Put Ratio Backspread Risk Graph

Thanks to mild gains this past week and time decay for the long options, the trade lost further ground. The long options are suffering from time decay more than the short options because more of their value is extrinsic. In fact, as of the close on June 26, theta, which is time decay, is taking away $2.17 a day from the long options, while the short options are only gaining 36-cents. Time decay only occurs on the extrinsic value of the option, or the time value. The long 38 options have 34-cents of extrinsic value, while the short 43 options have just 5-cents of extrinsic value.

What we would work best for this trade would be a sharp drop in the Qs, accompanied by a rise in fear. A gain in IV would accelerate our profits by increasing the value of the long puts more than the short puts. Let's look at an example to further show how IV impacts the trade's value.

Let's first assume that with a month left for these options that the Qs are trading at 32. If IV stays the same, the profit would be about $152. However, if IV were to increase just 10 percent, than the profit would be near $157. This equates to a profit increase of 3.3 percent. A 10 percent move might seem like a large move for IV, but it really isn't. Currently, IV on the long options sits at 24.0, which means a 10 percent gain would put IV near 26.4. The Qs have seen IV range from 25 to over 70 in the past year.

IV wouldn't mean anything if we held the trade until expiration, but it normally isn't smart to do this. The space on the risk graph between the blue and black lines is the loss we can avoid by getting out of the trade with 30-days left. This is because time decay is largest the last 30 days of an options life.

Please feel free to ask any questions and make comments on my discussion forum, which you may access through "Ask the Traders" from the Discussion board on the homepage of Optionetics.com.

To read previous installments of Real-World Trading, please click here.

Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
Visit Jody's Forum

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Recent Articles by Jody Osborne, Optionetics.com

• November 20, 2009
  Closing Wrap-Up, Nov. 20
• November 20, 2009
  Morning Watch, Nov. 20
• November 19, 2009
  Closing Wrap-Up, Nov. 19
• November 19, 2009
  Real-World Trading: Flying to Profits with an Iron Condor, Part II
• November 19, 2009
  Morning Watch, Nov. 19