Diagonal Bear Put Spread Explained

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Diagonal Bear Put Spread

The diagonal bear put spread strategy involves buying long-term puts and simultaneously writing an equal number of near-month puts of the same underlying stock with a lower strike.

This strategy is typically employed when the options trader is bearish on the underlying stock over the longer term but is neutral to mildly bearish in the near term.

Diagonal Bear Put Spread Construction
Buy 1 Long-Term ITM Put
Sell 1 Near-Term OTM Put

Limited Upside Profit

The ideal situation for the diagonal bear put spread buyer is when the underlying stock price remains unchanged and only goes down and below the strike price of the put sold when the long term put expires. In this scenario, as soon as the near month put expires worthless, the options trader can write another put and repeat this process every month until expiration of the longer term put to reduce the cost of the trade. It may even be possible at some point in time to own the long term put “for free”.

Under this ideal situation, maximum profit for the diagonal bear put spread is obtained and is equal to all the premiums collected for writing the near-month puts plus the difference in strike price of the two put options minus the initial debit taken to put on the trade.

Limited Downside Risk

The maximum possible loss for the diagonal bear put spread is limited to the initial debit taken to put on the spread. This happens when the stock price goes up and stays up until expiration of the longer term put.

Example

In June, an options trader believes that XYZ stock trading at $40 is going to drop gradually for the next four months. He enters a diagonal bear put spread by buying a OCT 40 put for $300 and writing a JUL 35 put for $100. The net investment required to put on the spread is a debit of $200.

The stock price of XYZ goes down by $1 a month and closes at $36 on expiration date of the long term put. As each near-month put expires, the options trader writes another put of the same strike for $100. In total, another $300 was collected for writing 3 more near month puts. Additionally, with the stock price at $36, the OCT 40 put expires in the money with $400 in intrinsic value. Thus, in total, his profit is $400 (intrinsic value of the OCT 40 put) + $300 (additional premiums collected) – $200 (initial debit) = $500.

If the price of XYZ had risen to $42 and stayed at $42 until October instead, both options expire worthless. The trader will also be unable to write additional puts since they are too far out-of-the-money to bring in significant premiums. Hence, he will lose his entire investment of $200, which is also his maximum possible loss.

Suppose the price of XYZ did not move and remains at $40 until expiration of the long term put, the trader will still profit as the total amount of premium collected is $400 while the OCT 40 put cost $300, resulting in a $100 profit.

Note: While we have covered the use of this strategy with reference to stock options, the diagonal bear put spread is equally applicable using ETF options, index options as well as options on futures.

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Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the diagonal bear put spread in that they are also bearish strategies that have limited profit potential and limited risk.

Diagonal Spread w/Puts

NOTE: This graph assumes the strategy was established for a net debit. Also, notice the profit and loss lines are not straight. That’s because the back-month put is still open when the front-month put expires. Straight lines and hard angles usually indicate that all options in the strategy have the same expiration date.

The Strategy

You can think of this as a two-step strategy. It’s a cross between a long calendar spread with puts and a short put spread. It starts out as a time decay play. Then once you sell a second put with strike B (after front-month expiration), you have legged into a short put spread. Ideally, you will be able to establish this strategy for a net credit or for a small net debit.

For this Playbook, I’m using the example of one-month diagonal spreads. But please note, it is possible to use different time intervals. If you’re going to use more than a one-month interval between the front-month and back-month options, you need to understand the ins and outs of rolling an option position.

Options Guy’s Tips

Ideally, you want some initial volatility with some predictability. Some volatility is good, because the plan is to sell two options, and you want to get as much as possible for them. On the other hand, we want the stock price to remain relatively stable. That’s a bit of a paradox, and that’s why this strategy is for more advanced traders.

To run this strategy, you need to know how to manage the risk of early assignment on your short options.

The Setup

  • Sell an out-of-the-money put, strike price B (near-term expiration – “front-month”)
  • Buy a further out-of-the-money put, strike price A (with expiration one month later – “back-month”)
  • At expiration of the front-month put, sell another put with strike B and the same expiration as the back-month put
  • Generally, the stock will be above strike B

Who Should Run It

Seasoned Veterans and higher

NOTE: The level of knowledge required for this trade is considerable, because you’re dealing with options that expire on different dates.

When to Run It

You’re expecting neutral activity during the front month, then neutral to bullish activity during the back month.

Break-even at Expiration

It is possible to approximate break-even points, but there are too many variables to give an exact formula.

Because there are two expiration dates for the options in a diagonal spread, a pricing model must be used to “guesstimate” what the value of the back-month put will be when the front-month put expires. Ally Invest’s Profit + Loss Calculator can help you in this regard. But keep in mind, the Profit + Loss Calculator assumes that all other variables, such as implied volatility, interest rates, etc., remain constant over the life of the trade — and they may not behave that way in reality.

The Sweet Spot

For step one, you want the stock price to stay at or around strike B until expiration of the front-month option. For step two, you’ll want the stock price to be above strike B when the back-month option expires.

Maximum Potential Profit

Profit is limited to the net credit received for selling both puts with strike B, minus the premium paid for the put with strike A.

NOTE: You can’t precisely calculate potential profit at initiation, because it depends on the premium received for the sale of the second put at a later date.

Maximum Potential Loss

If established for a net credit, risk is limited to the difference between strike A and strike B, minus the net credit received.

If established for a net debit, risk is limited to the difference between strike A and strike B, plus the net debit paid.

NOTE: You can’t precisely calculate your risk at initiation, because it depends on the premium received for the sale of the second put at a later date.

Ally Invest Margin Requirement

Margin requirement is the difference between the strike prices (if the position is closed at expiration of the front-month option).

NOTE: If established for a net credit, the proceeds may be applied to the initial margin requirement.

Keep in mind this requirement is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.

As Time Goes By

For this strategy, before front-month expiration, time decay is your friend, since the shorter-term put will lose time value faster than the longer-term put. After closing the front-month put with strike B and selling another put with strike B that has the same expiration as the back-month put with strike A, time decay is somewhat neutral. That’s because you’ll see erosion in the value of both the option you sold (good) and the option you bought (bad).

Implied Volatility

After the strategy is established, although you want neutral movement on the stock if it’s at or above strike B, you’re better off if implied volatility increases close to front-month expiration. That way, you will receive a higher premium for selling another put at strike B.

After front-month expiration, you have legged into a short put spread. So the effect of implied volatility depends on where the stock is relative to your strike prices.

If your forecast was correct and the stock price is approaching or above strike B, you want implied volatility to decrease. That’s because it will decrease the value of both options, and ideally you want them to expire worthless.

If your forecast was incorrect and the stock price is approaching or below strike A, you want implied volatility to increase for two reasons. First, it will increase the value of the near-the-money option you bought faster than the in-the-money option you sold, thereby decreasing the overall value of the spread. Second, it reflects an increased probability of a price swing (which will hopefully be to the upside).

Check your strategy with Ally Invest tools

  • Use the Profit + Loss Calculator to estimate break-even points, evaluate how your strategy might change as expiration approaches, and analyze the Option Greeks.
  • Use the Option Pricing Calculator to “guesstimate” the value of the back-month call you will sell at strike B after closing the front-month put.

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Diagonal Spread

What Is a Diagonal Spread?

A diagonal spread is an options strategy established by simultaneously entering into a long and short position in two options of the same type (two call options or two put options) but with different strike prices and different expiration dates. Typically these structures are on a 1 x 1 ratio.

This strategy can lean bullish or bearish, depending on the structure of the options.

How a Diagonal Spread Works

This strategy is called a diagonal spread because it combines a horizontal spread, also called a time spread or calendar spread, which represents the difference in expiration dates, with a vertical spread, or price spread, which represents the difference in strike prices.

The names horizontal, vertical and diagonal spreads refer to the positions of each option on an options grid. Options are listed in a matrix of strike prices and expiration dates. Therefore, options used in vertical spread strategies are all listed in the same vertical column with the same expiration dates. Options in a horizontal spread strategy use the same strike prices, but are of different expiration dates. The options are therefore arranged horizontally on a calendar.

Options used in diagonal spreads have differing strike prices and expiration days, so the options are arranged diagonally on the quote grid.

Types of Diagonal Spreads

Because there are two factors for each option that are different, namely strike price and expiration date, there are many different types of diagonal spreads. They can be bullish or bearish, long or short and utilize puts or calls.

Most diagonal spreads refer to long spreads and the only requirement is that the holder buys the option with the longer expiration date and sells the option with the shorter expiration date. This is true for call strategies and put strategies alike.

Of course, the converse is also required. Short spreads require that the holder buys the shorter expiration and sells the longer expiration.

What decides whether either a long or short strategy is bullish or bearish is the combination of strike prices. The table below outlines the possibilities:

Diagonal Spreads Diagonal Spreads Expiration Dates Expiration Dates Strike Price Strike Price Underlying Assumption
Calls Long Sell Near Buy Far Buy Lower Sell Higher Bullish
Short Buy Near Sell Far Sell Lower Buy Higher Bearish
Puts Long Sell Near Buy Far Sell Lower Buy Higher Bearish
Short Buy Near Sell Far Buy Lower Sell Higher Bullish

Example of a Diagonal Spread

For example, in a bullish long call diagonal spread, buy the option with the longer expiration date and with a lower strike price and sell the option with the near expiration date and the higher strike price. An example would be to purchase one December $20 call option and the simultaneous sale of one April $25 call.

Logistics

Typically long vertical and long calendar spread results in a debit to the account. With diagonal spreads, the combinations of strikes and expirations will vary, but a long diagonal spread is generally put on for a debit and a short diagonal spread is setup as a credit.

Also, the simplest way to use a diagonal spread is to close the trade when the shorter option expires. However, many traders “roll” the strategy, most often by replacing the expired option with an option with the same strike price but with the expiration of the longer option (or earlier).

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