[Music] hey everyone welcome back to the show thanks so much for tuning in my name is mike this is my whiteboard and we're going to continue on with our trade entry checklist today with the put ratio spread we're going to look at a front ratio spread and we're going to talk about some things that we look for when placing this trade and a few reasons why i love this strategy specifically for long stock trade entry and we'll get into how i can calculate my awesome break even with the strategy and a few other good points on building the strategy up and deploying it in certain environments so let's get right going with it and we'll start off with just breaking down the initial trade so when we're looking to trade a put front ratio spread basically a front ratio spread is really just where we're selling more options than we're buying a back ratio spread would be where we're buying more options than we're selling so since we're selling two options for every one option we're buying this would be a front ratio spread the best thing about this spread is we're going to route it for a credit where normally it would come up as maybe a small debit or even money but in our cases in a perfect scenario where we're going to create that we're going to route that for a credit there's a few reasons why we're going to do that one thing to realize with this spread is that it's really just a long put spread and a short put combined so you can see i've got a long out of the money put spread here and i'm just selling an extra short put against that to reduce my cost basis and turn this trade from a debit which would normally be that long put spread aspect and route it for a credit by selling that additional put so when we do this for credit we can be profitable in multiple situations so we're selling this out of the money front ratio spread here and we're looking to basically either have this entire spread expire out of the money which would allow us to keep that initial credit or we want it to basically pin that short strike here because that's where our max profit will be realized and we'll talk a little bit more about that but first we're going to look at our assumption well first of all we're going to be profitable in a lot of different scenarios here but where we're most profitable is if the stock goes down so for that reason i'm going to list my assumption on this trade to be neutral to bearish if we're neutral on the underlying or if the stock doesn't move all three of these options would expire out of the money and be worthless which allows us to keep that initial credit we received as profit but if our stock price goes down to our short strike we're going to realize maximum profit on this trade which is why we have that bearish bearish tendency or we replace this underlying or place a strategy in an underlying where we think that stock's going to come down a little bit having this strategy in a higher iv environment is going to be optimal because it's going to help us route this trade for credit and most likely get more of a credit than we normally would in a lower implied volatility environment which just benefits our situation where if the stock price doesn't move we're able to collect more credit and if these options expire out of the money we're going to be more profitable in that high iv environment than a low iv environment but let's talk a little bit about what happens when the stock goes up stays the same or goes down on the next slide here so if the stock goes up the very first thing to keep in mind is again that these contracts will lose value and we could see implied volatility contract there tends to be this relationship with implied volatility and stock price movement or market movement where if the market goes up we usually see implied volatility come down and if the market goes down we usually see implied volatility go up so when a stock goes up in this particular example the contracts will definitely lose value just because they're moving further and further out of the money if the stock price comes up here there's much more distance between our strikes than the stock price as we have in this initial setup here so the further the stock price is from our short strikes in terms of being out of the money the lower value those options are going to have which could allow us to potentially buy back the spread for a lower amount or just have a higher probability of those options expiring worthless which would be great for us so that's why i've got that highlighted in green if the stock goes up when we're selling this for a credit and we're routing this trade for credit that's going to be good for us and we're going to be able to profit if those options stay out of the money if the stock price stays the same we do have theta decay working for us and all these contracts are going to lose value so it's going to be bad for our long put that it's losing value but we basically double down on the short puts here so the benefits of theta decay are going to be working for us more on those short options than they will be offsetting us on that long option and since we routed this for a credit we know that we have a positive theta strategy to begin with any trade that we have like this where we have a positive theta aspect we're rounding it for a credit there's no way we can really route something for a debit and have that positive theta decay other than when we trade it for less than intrinsic value but for this specific example we're selling this for a credit and we have two options that we sold compared to the one that we bought so we're going to have a positive theta aspect for throughout pretty much this whole trade so i've got that listed in green here as well when with the when the stock price goes down though i do have a red box around this one because we want that stock price to go down but we want it to stop right around our short strikes or even anywhere in between this zone because that's going to help our long put gain value while our short puts would still be out of the money anywhere in between our long put and our short put strikes we're still going to have these short put strikes expire out of the money and the further down this goes the more value our long put will have but if we go down too far our extra short put will start to be a loser so we will be able to see full profit if the stock price goes well below the short options because we have this long put spread which would be at maximum profit but the further and further that goes we're going to see losses on that short put so it's really important to realize that yes we do want that stock to go down but the short option that we're held with and the short option that we have extra will begin to lose more and more the more that that stock price goes down so we don't want it to go down too far we just want it to go down to right around our short strike and that's where we're going to realize max profit but let's talk about some ways that we look at the strategy perspective on the next slide so the very first thing we need to do is figure out how we can easily calculate our breakeven so this is one of the best parts about this strategy and why i love this as a stock entry strategy because my break even is much much lower than if i were to have just sold this put out right so let's talk a little bit about that the very first thing i need to do to calculate my breakeven is just go to my short strike my long option is going to gain value the further down we go but i'm going to potentially start losing money the further we go down past that short strike so to calculate that i need to start at my short strike and then i need to subtract my long put spread width so let's say our short strike is at 90 here let's pretend the stock price is at 100 and let's say i've got the long put at 95. so i have a five point wide long put spread and both of my short options are on the 90 strike and let's pretend i collected 50 cents of credit so what i need to do is take my short strike of 90 subtract the long put spread width which is 5 points wide again if i've got a 95 long put here and we're looking at my 90 short put there that's 5 points wide so i would take 90 subtract 5 from that and then subtract my 50 cent credit from that so that would bring me to 85 just from that long put and then another 50 cents which brings me down to 84. 50 so even though my short strikes are at 90 my break even is at 84.
50 because of the fact that i'm going to have that maximum profit on the long put spread here of five points that i can use to offset my breakeven even further to the downside so when we compare that to just selling the put outright let's say i was able to potentially just sell a put for a dollar on that 90 strike if i sold that put for a dollar my break even would still be at 89 which is good but when we compare it to this strategy of my break even being at 84. 50 it pales in comparison so that's why i love this strategy as a long stock entry point and it gives us the benefit of being profitable if that stock goes down so again the iv factor here it's going to be better in a high iv environment because we're going to be able to collect that pred that credit a lot easier when i'm paying for that long put option the higher implied volatility is going to increase the value of these short put options yes it's going to increase the value of my long put as well but i should be able to route that for credit much easier when the further out of the money options in those short strikes have more value so we're really looking for that high iv factor for this strategy and because we're routing it for credit a decrease in implied volatility will help us lose value in those options which is going to help us buy back that spread for a lower cost or just let those options expire out of the money when we look to close this this strategy we're not looking at 50 of the credit received in a lot of our standard options selling or premium selling strategies where we're looking at maybe selling a put spread or selling a call spread or selling a strangle or straddle we're looking at that 50 profit potential from the credit received but in this particular strategy we're going to be routing it for a small credit let's say maybe if we use that same example we're routing this for a 50 cent credit but i have an embedded long put spread here of five points so i know that my max profit is my credit that i received initially plus the width of that long put spread so if the stock price goes to that 90 strike and stays right there at expiration i'm going to have a long put that's worth 500 because this would be 5 points in the money if this is at 95 and the stock price is at 90 then this long put is going to be worth 500 and i know that i collected a net credit of 50 cents for the trade and if the stock price is right on these short strikes at expiration and not one penny in the money both of these strikes are going to expire worthless so i'm left with a long put that i can then close or sell out back to the market for 500 and i already collected 50 cents for the initial trade which brings my max profit to 550 so i'm going to look at potentially closing this prior to expiration at a level of around 250 or 275 dollars 275 would be that 50 max profit and as you can see that's not that 50 credit we initially received i wouldn't look to close this this strategy if i see a 25 profit where the credit might have come down or the trade might have come down to a value of 25 cents i'm going to wait until that stock price actually breaches my long strike and hopefully i can get close to that 50 of max profit or 275 dollars sometime within that trade life cycle so it's really important to realize that the max profit on this strategy is not the credit received it's actually the difference between the long strike and our short strike which is our embedded long put spread plus that credit we initially received for routing this trade so let's wrap all this up with some takeaways for you the very first takeaway here is that we have a neutral to bearish cost basis reduction strategy we can be profitable if the spread expires worthless or we can be profitable if the stock price goes down to our short strike and even if it breaches that short strike our break even is so much better than if we were to have just sold that put because of that long put embedded spread in there we're able to move it all the way down to 84.
