Put Backspread

Components

Long two OTM put options and short one ITM put option.

Risk / Reward

Maximum Loss: Limited to the difference between the two strikes less the premium received for the spread.

Maximum Gain: Limited on the upside to the net premium received for the spread. Unlimited on the downside.

Characteristics

When to use: When you are bearish on market direction and bullish on volatility.

This strategy could also be referred to as a Short Put Backspread, however, I will refer to this strategy simply as a Put Backspread.

A Put Backspread should be done as a credit. This means that after you buy 2 OTM puts and sell 1 ITM put the net effect should be a credit to you. I.e. you should receive money for this spread as your are short more than you are long.

Put Backspread's are a great strategy if you are bullish and bearish at the same time, however, have a bias to the downside. Looking from the payoff, you can see that if the market sells off you make unlimited profits below the break even point. If, however, you are wrong about the direction and the market stages a rally instead, you still win - though your profits are limited.

You might say that this type of strategy is similar to a Long Straddle - and you would be right. The difference is that 1) the profits are limited on one side and 2) Backspread's are cheaper to put on.