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Diagonal Put

Description

Description

Stock Options Strategy Guide - Long Call

Steps to buying a Diagonal Put

  1. Sell lower strike short term expiration puts
  2. Buy the same number of higher strike longer term puts with longer to expiration.

Steps In

  • Choose from stocks with adequate liquidity, preferably over 500,000 Average Daily Volume (ADV)
  • Try to ensure that the trend is downward or rangebound and identify a clear area of resistance.


Steps Out

  • Manage your position according to the rules defined in your Trading Plan.
  • If the stock closes below the lower strike at expiration, you will be exercised. You will sell your long put, buy the stock at the short put strike price, deliver it at the lower market price, whilst having profited from both the option premium you received and the uplift in the long put option premium. Exercise of the short option is automatic. Do not exercise the long option or you will forfeit its time value. If you're going to be exercised then it's best to simply reverse the entire position and close the trade the day before expiration.
  • If the stock remains above the lower strike but below your stop loss, let the short put expire worthless and keep the entire premium. If you like you can then write another put for the following month if you're still neutral to bearish on the stock.
  • If the stock rises above your stop loss, then either sell the long option (if you're approved for naked put writing), or reverse the entire position.

Context

Your Outlook

  • With a Diagonal Put, your outlook is bearish.

Rationale

  • To generate income against your longer term long put position by selling puts and receiving the premium.

Net Position

  • This is a net debit transaction because your bought puts will be more expensive than your sold puts which are OTM and have less time value.
  • Your maximum risk on the trade itself is limited to the net debit of the bought puts less the sold puts. Your maximum reward occurs when the stock price is at the sold put (lower) strike price at the expiration of the sold put.

Effect of Time Decay

  • Time decay affects your Diagonal Put trade in a mixed fashion. It erodes the value of the long put but can help you with your income strategy by eroding the value faster on the short put.

Appropriate Time Period to Trade

  • You will be safest to choose a long time to expiration with the long put and a shorter time (say 1 month) for the short put.

Risk Profile

Selecting the Stock

  • Choose from stocks with adequate liquidity, preferably over 500,000 Average Daily Volume (ADV).
  • Try to ensure that the trend is downward or rangebound and identify a clear area of resistance.

Selecting the Option

  • Choose options with adequate liquidity, open interest should be at least 100, preferably 500.
  • Lower Strike: Look for OTM by more than one strike below the current stock price to enable the long put to rise in value if you get exercised on the short put.
  • Higher Strike: Look for either the ATM or ITM (ideally about 10-20% ITM preferred) strike above the current stock price. If you're bearish, then choose a higher strike, if neutral choose the ATM strike in anticipation of writing more puts in the future.
  • Expirations:Look at either of the next 2 expirations for the short option and compare monthly yields. Look for over 6 months for the long option.


Maximum Risk
  • Limited to the net debit paid
Maximum Reward
  • [long put value at the time of the short put expiration, when the stock price is at the lower strike price] less [net debit]
Breakeven Down
  • Depends on the value of the long put option at the time of the short put expiration.
Breakeven UP
  • Depends on the value of the long put option at the time of the short put expiration.

The Greeks

The Greeks

Expiration
Today - 5 months
Time(t) - 1 month

Theta

Theta is positive when the position is profitable and negative when the position is making a loss. In other words time decay is helpful when we're in profit and unhelpful when we're making a loss.

Delta

Delta (speed) is at its fastest either side of the strike price, indicating the increasing speed of the position in one direction and then the other
LongCall

Vega

Increasing volatility is helpful because it will mean the long put's residual value should be higher.

Gamma

Gamma (acceleration) peaks inversely around the higher strike price, showing where the delta line is steepest.

Rho

Lower interest rates become more unhelpful as the underlying asset price falls.

Exiting the Position

Exiting the Position

  • With this strategy you can simply unravel the spread by buying back the puts you sold and selling the puts you bought in the first place.
  • Advanced traders may leg up and down as the underlying asset fluctuates up and down. In this way you can take incremental profits before the expiration of the trade.

Mitigating a loss

  • Unravel the trade as above.
  • Advanced traders may choose to only partially unravel the spread leg by leg. In this way they will leave one leg of the spread exposed in order to attempt to profit from it.

Pros and Cons

Advantages

  • Generate (monthly) income.
  • Can profit from rangebound stocks and make a higher yield than with a Covered Put or Naked Call.

Disadvantages

  • Capped profits if the stock falls
  • If poorly constructed, the Diagonal Put can lose if the stock falls significantly and you haven't either bought deep enough ITM, or sold far enough OTM away
  • High yield does not necessarily mean a profitable or high probability profitable trade