Diagonal Put Spread
The Diagonal Put Spread is an advanced options trading strategy similar to the diagonal call spread but uses put options instead. This is a strategy that involves buying a long-term put option at a higher strike price while selling a short-term put option at a lower strike price. In general, this is used as a strategy to benefit from downward price movements of the underlying asset over time, combined with the benefits of time decay on the sold put.
The Diagonal Put Spread Setup
You are looking at a stock XYZ that is trading at $100. You can set up a diagonal put spread by:
- Buying a long-term put option with a strike price of $105 expiring in six months, for which you pay a premium of $12.
- Selling a short-term put option with a strike price of $95 expiring in one month, for which you receive a premium of $4.
Who Should Consider It
This strategy is appropriate for traders who expect a slow drop in the price of the stock but want to reduce the cost of purchasing a long-term put. It is ideal for moderately bearish people on the underlying asset and wish to benefit from the accelerated time decay of the near-term sold put.
The diagonal put spread aims to make a profit from the decline in the price of the underlying asset over time and benefit from the decay of the premium of the short-term put option. Flexibility in managing the trade is provided by different strikes and expirations to adjust for price movements and volatility changes.
The breakeven point of a diagonal put spread is not fixed and depends on the value of the long put at the expiration of the short put. It generally occurs when the reduction in the asset’s price offsets the initial net cost of the spread, that is, the cost of the long put minus the credit from the short put.
The optimal scenario (sweet spot) is when the stock price is slightly above the strike price of the short put at its expiration, allowing the short put to expire worthless or be closed at a minimal cost, while the long put retains significant extrinsic and intrinsic value.
Theoretically significant, the maximum profit in this case is the profit of such a deal that increases as the stock price drops significantly below the strike price of the long put. The potential for profit is highest if stock price falls significantly below the strike prices of both options after the short put expires.
The maximum loss is capped at the initial net outlay for the spread (the cost of the long put minus the premium received for the short put). This is the case when the stock price is at or above the strike price of the long put at expiration and therefore worthless as well as both options.
The main risk is the stock price not declining as anticipated, or declining too slowly, resulting in a potential total loss of the net premium paid. Also, if the stock price falls below the strike of the short put before it expires, you might face additional risks and need to manage the position actively.
Time decay, or theta, works in favor of this strategy, especially as the short put is approaching expiration. The short put decays faster than the long put because it is closer to expiration, and if the stock price stays above the strike price of the short put, then the accelerated decay can be profitable.
Changes in implied volatility have a complex effect on this strategy since it involves long and short put positions. Generally, an increase in volatility benefits the long put more significantly than it harms the short put, particularly if the stock price is near or below the strike price of the long put.
A diagonal put spread is a good strategy for traders expecting a moderate fall in the underlying asset. This is because it allows for the optimal balance of risk and possible returns by capitalizing on differential decay rates between short-term and long-term options as well as on the differing impacts of volatility. This allows a trader to effectively manage his or her costs while positioning for a possible decline in the stock price.