Put Diagonal Spread

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In today's video, I want to talk about a put diagonal spread, a strategy that you can use in bullish directional trades in low volatility environments.

You can think of a put diagonal as basically a two-part strategy, and that's because it's a cross between a long calendar spread and a short credit put spread. It’s a cross between a long calendar spread, and a short credit put spread.

Having features of both of these basic strategies, this is a more advanced strategy which profits from both the decay in the option price differentials between the contract months and a general upward directional movement in the underlying stock.

This is exactly how you’d setup that strategy. The first thing that you’re going to do is sell one out of the money front month put option. You’re going to sell one out of the money front month put option probably a couple of strikes out of the money.

The next thing you’re going to do is go to the back-month put options, and you’re going to buy an out of the money put option at some lower strike.

The key here is that the wider that you get the difference between your strikes, the front-month strike that you sell and the back-month strike that you buy, the wider that differential becomes, the more directional your trade will be as it relates to the stock.

What’s the risk? If you establish this position for a net credit which you sometimes can do, the risk is limited to the difference between the strike prices minus your net credit received.

If it’s established for a net debit which it’s established for a net debit, your risk is limited to the difference between the strike prices plus the net debit that you paid.

As far as profit potential, it can vary with this strategy because of the different decay in the options between the front and back month.

But generally, your profit is limited to the credit that you receive from selling the front month option minus the premium that you paid for the back-month put option that you bought. We’ll ideally see this happen when the market closes at the short strike of that front month option that you sold.

Volatility or Vega will have a pretty positive impact on this position everything else being equal, and that’s because, with these positions, they’re very similar to calendar spreads. Increased implied volatility will have a good impact on these positions.

They boost the value of that back month option compared to the negative impact of that front month option that we’re short. Likewise, the passage of time will help this position since we’re looking to collect the value of that front month option that we sold.

That’s our target. The closer we get to expiration, the faster a profit will start to materialize. The breakeven points with these put diagonal spreads are hard to calculate. There’s no single way to do it.

You can’t determine the breakeven prices on these. Because of just the decay in options, it tends to shift and move. It’s important that you always analyze the trade first before placing an order.

What we’re going to do is go to my broker platform now on Thinkorswim, and we’re going to analyze a trade that we can put on right now in SPY.

We’re going to make a trade in SPY, the stock is currently trading at a little over 203 and closed out the day at 203, so what we’re going to do is we’re going to look to do a put diagonal spread using all of the puts for both February which is going to be our front month option and March which is going to be our back month option.

You can see these are the two different months that we’re going to trade and work off of. I’m just going to expand out the number of contracts that we can select from here first.

The first thing I want to do is I want to sell an out of the money put option in the front month. In this case, we’ll go two strikes out and go to the 202 put options. We're going to sell the 202 put options which are the one I just clicked on.

Then what we’re going to do is go a couple of more strikes out, and in this case, we’ll go down to the 199s in March, and we’re going to buy these options that are out of the money and at the 199 strike.

You see we’re selling the 202s in February and going out to the March contracts and buying the 199s which are lower. In this case, it does end up with a net debit on the trade. I’ll show you guys’ how you can create a credit for this trade, but first, we’re going to start here with this trade that did end up as a net debit.

When we go to the risk profile, you can see that it’s got that very similar shape to this strategy profit and loss diagram that we had in the slides. It looks like a calendar, but it were skewed and tilted on this side of the market, and that’s because we’re getting a little bit more bullish in our directional trade.

You can see the stock is trading right at 203, so ideally, we would make money somewhere between about 199 or so and about 210. That’s our breakeven points on this trade as it stands right now.

If the stock continues to move much, much higher as it rallies higher, you can see that our loss differential is much lower with a put diagonal spread as it is with just a basic calendar spread that you would trade.

If the stock does end up falling lower, you can see we’re taking a little bit more risk on the bottom side of our trade because of the way that the trade is structured, so ideally, we do want the stock to be rallying higher and we want to be trading in a low implied volatility environment.

One of the ways that we can create a credit is by widening the differential in our strike prices. In this case, right now, the differential is only $3 wide, so if we wanted to take in a credit on this trade, we would move the March options that we bought down to a further strike.

I’m just going to do this extreme here and try to take in credit. I moved it all the way down from 199 to 195. You can see now; the differential is about $7. That leaves us with a net credit on the trade.

You can see what that did is that moved in our breakeven point just a little bit closer on the bottom side of our trade and now has left us an opportunity to make a net credit if the market does in fact rally higher. It just doesn’t leave us as much room for the market to move lower, but you can, in fact, do these trades for a net credit.

Some of the key takeaways from this strategy are that they are low implied volatility strategies that work best when you have more of a directional assumption on the underlying stock.

We do prefer to enter these trades for a net credit, but sometimes that just isn’t the case. Just make sure that you’re always looking at that analyze tab and looking at the different prices between the months.

We suggest closing out the spread completely at the front-month expiration whenever possible. This one says whoever. It’s whenever possible. What that means is that once we get to that front month expiration which in our case was the February expiration, we’re going to want to look to close out the trade.

We’re not going to carry it over into March just holding some long option position unless it’s very, very cheap. As always, I hope you guys enjoy these videos. If you have any comments or questions, please add them right below on the lesson page. Until next time, happy trading!