Investors think Cisco (NASDAQ: CSCO) is poised for a pullback

Cisco Systems (NASDAQ: CSCO) has had an exciting few weeks. Since February 1, the stock has enjoyed a sharp trajectory higher, gaining almost 15%. The tech world has been anticipating the release of a new Cisco router, which is expected to improve the flow of information – in fact, Cisco officials claim the new device will “forever change the Internet.”

Some skeptics emerged, however, in the form of advanced options traders, who executed a put ratio backspread to express a short-term bearish view on the stock. In this trade, the backspread seller sold a large block (4,850, to be specific) of the April 26 puts for 74 cents per contract and then bought twice as many (9,700) of the April 24 puts for 19 cents each. The net credit collected was 36 cents (74 minus 19 minus 19).

While the put backspread strategy is the most successful when the stock declines, it yields a modest profit (the 36 cents collected at the outset) if CSCO rallies above 26. At 26 or anywhere north of it, both puts expire worthless and the trader keeps the 36 cents (and has no exit commissions to pay, to boot).

The worst-case scenario, at expiration, is for CSCO to trade right at 24. At this point, short 26-strike put is worth two bucks, and one of the 24 puts has to be exercised to compensate for it. The maximum loss, therefore, is $1.64, or two minus the initial credit of 36 cents. Below the lower breakeven price of $22.36 (24 minus the maximum loss), the spread can profit as long as the underlying stock falls. The upper breakeven price, incidentally, is $25.64 (or the short put strike minus the credit collected).

That’s a lot of math, so let’s take a look at a profit/loss graph build using a virtual trading account. Note how, at expiration, the maximum loss is at 24, while gains rise as the stock value falls. Prior to expiration, the spread will profit as the stock declines, but the losses at 24 will not be as dramatic until expiration looms.

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