After a face-ripper rally that started in November, all major indices in the U.S. stock market are overextended to the upside. There’s a way for traders to bet on a decline in stocks into year-end that won’t burn them if the market keeps on rallying. In fact, they could still turn a profit. The below chart shows that the SPDR Dow Jones Industrial Average ETF Trust (DIA) has been in overbought territory since late November. Although this doesn’t guarantee that a pullback will happen anytime soon, markets become vulnerable when they are overstretched like this. If we look at recent history, DIA was overbought back in July 2023 and this was followed by a three-month long sell-off. If a trader expects an outsized downward move on a stock or ETF, the simplest way to make money is to buy OTM (out-of-the-money) put options. But put options can be very expensive. The 30 delta puts on DIA are currently trading at $1.55. If a trader wants to buy 20 contracts of these “cheap” put options, it would cost them $1.55 times 20 contracts times 100 (option multiplier of 100x) equaling $3,100. (Delta measures the movement of an option for every $1 move in a stock’s price.) That is a sizable chunk of change. Further, if the trader is directionally wrong, and the markets keep melting up, they stand to lose their entire investment. Put ratio backspread Consider a put ratio backspread, which is a trade that can generate zero loss even when a trader is wrong on the direction. The nice thing about this trade is that even if I am wrong on direction, I can avoid losing any money. And if done right, I even can make a tiny profit if I’m wrong. Trade structure As in the example of buying OTM put options above, I will still buy 20 contracts of $358 put options. That will still cost me $3,100. But I will finance that purchase by selling 10 contracts of the ATM (at-the-money) $364 puts at $3.30 per contract. This gives me a credit of $3.30 (10 (contracts) times 100 (option multiplier of 100x) equals $3,300). By doing this I get to put on this trade for a net credit ($3,300 – $3,100 = $200). This is how the math works out: Buy 20x $358 puts at 1.55 = $3,100 debit Sell 10x 364 puts at 3.30 = $3,300 credit Total Cost = +$200 (i.e a credit of $200) Possible outcomes: Avoid the ‘valley of death’ There are 3 possible outcomes of this trade. 1. DIA keeps going up : If I am 100% wrong on direction and markets keep melting up until Jan 5 th (the expiration date for my puts), I will end up making $200 in profit. How nice to get paid when I am totally wrong. 2. DIA goes into a sizable pullback : This is the best case scenario, and this is where I get to make my money. If you notice, my entire thesis for putting on this trade is that markets are overdue for a correction, and we are likely to see a sizable pullback in the next 25 days. If that does happen, and even if DIA drops a mere 3.8% to the 350 area, I will make approximately $2,300 on this trade. If DIA keeps dropping further, there is no upside limit to the profits. Eg. If DIA drops to 340 which is only a 6% drop, this trade will net me a cool $12,000. 3. Is there a catch? When it sounds too good to be true, it usually is. So far, it sounds like an amazing trade where I get paid whether I am directionally right or wrong. However, I am banking on DIA making an outsized downward move to make profits on this trade. If for some reason, DIA drops only slightly below $364, there is an area of danger called the “valley of death”, which can cause this trade to be a loser. The valley of death as shown below is between $352 and $364. This is where trade management rules will come into play and I could close this trade when it reaches my loss tolerance. Summary: Ratio backspreads are best suited for situations when one expects a big move in the underlying. This trade is not suitable where markets are range-bound and there is little to no price movement. Due to the imbalanced structure of the trade (traders buy 2x more options than they sold), it has the potential of generating outsized returns. If the trade is majorly directionally wrong, there is no loss. In fact, the trade can be put on for a small credit. This is where it shines as opposed to just buying put options. With put options, a trader can lose their entire investment if they are directionally wrong. The trade relies on an outsized move to generate sizable profits. However, if the underlying does not move a lot and falls into the “valley of death”, the trade will cause losses and a good trade management plan will need to be used to cap those losses. —Nishant Pant Founder: https://tradingextremes.com Author: Mean Reversion Trading Youtube, Twitter: @TheMeanTrader DISCLOSURES: ( Nishant has a DIA put back/ratio spread expiring on 1/12/2024) THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.
