Bearish put diagonal spreads may be opened for a debit. This strategy guide focuses on bullish put diagonal spreads.
The strategy is successful if the underlying stock price is above the short put at the front-month expiration. The back-month long put option serves as protection and defines the strategy’s risk if the stock price is below the short put at the front-month expiration.
Put Diagonal Spread market outlook
A put diagonal spread is entered when an investor believes the stock price will be neutral or bullish short-term. The near-term short put option benefits from a rise in price from the underlying stock, similar to a bull put spread. The long put option will retain value better than a standard bull put spread because of its extended time horizon. An increase in volatility will also help add value to the long contract’s premium and potentially help offset a decline in value from the increasing stock price.
The objective is for the underlying stock price to close above the short put option at the first expiration date. The short put option would expire worthless, and the long put option would still have extrinsic value. At this point, an investor could choose to close the long put option or continue to hold the position if they believe the stock will reverse and go lower. Another short put option could also be sold to bring in additional credit. The short contract would need to have the same expiration date as the long put. This would create a traditional spread position.
How to set up a Put Diagonal Spread
A put diagonal spread is a combination of a bull put credit spread and a put calendar spread. A put diagonal spread is created by selling-to-open (STO) a put option and buying-to-open (BTO) a put option at a lower strike price, with a later expiration date.
Put diagonal spreads are typically opened for a credit, though a debit may be paid. The pricing at entry is dependent on the width of the spread between the two strike prices and the time until the expiration of the contracts. A tight spread width will result in a larger debit because the long option will be closer to the money and have more value. More time until expiration equates to more expensive options pricing and will also impact whether the position is opened for a debit or credit.
The width of the spread, minus the initial credit, is the maximum risk for the trade if the short put option is in-the-money and both options are closed at the front-month expiration. If the short put expires out-of-the-money, the long put may be sold for its extrinsic value. The credit received from selling the long put, plus the original credit received, will be the realized profit. The profit potential is unlimited if the short put expires worthless and the underlying stock price drops and/or implied volatility has a significant increase.
Put Diagonal Spread payoff diagram
The payoff diagram for a put diagonal spread is variable and has many different outcomes depending on when the options trader decides to exit the position. The maximum risk is defined at entry by the width of the spread minus the credit received.
If the stock price is below the short put at the front-month expiration, the option would need to be exited to avoid assignment. The long put may also be sold at the front-month expiration, or the investor could continue to hold the option if they believe the stock price will continue to decline. This would increase the maximum risk on the trade as the long put has the potential to expire out-of-the-money worthless.
If the stock price is above the short put strike at the front-month expiration--which is the goal of the diagonal spread--the short contract will expire worthless. The long put option will still have extrinsic time value. The investor can choose to exit the long put at this point or continue to hold the position.
For example, suppose a stock is trading at or above $50, and an investor believes the stock will stay above $50 in the near future. In that case, a put diagonal spread could be entered by selling a $50 put option and purchasing a $45 put option with a later expiration date. If the position collects $1.00 in credit, the max loss at the front-month expiration would be -$400.
The max potential profit will be variable and depend on whether the long put is closed at the front-month expiration. However, if a credit is collected when the trade is entered, and the short put expires worthless, the $100 credit will be a guaranteed profit. The long put could be sold at the front-month expiration to create additional profit, or the long position could be held if the investor believes the underlying stock price will decline.
Entering a Put Diagonal Spread
A put diagonal spread consists of selling-to-open (STO) a short put option and buying-to-open (BTO) a long put option at a lower strike price and a later expiration date.
For example, suppose a stock is trading at or above $50, and an investor believes the stock will stay above $50 in the near future. In that case, a put diagonal spread could be entered by selling a $50 put option and purchasing a $45 put option with a later expiration date. The farther out-of-the-money the strike prices are at trade entry, the more bearish the outlook on the underlying stock price.
Exiting a Put Diagonal Spread
The decision to exit a put diagonal spread will depend on the underlying asset’s price at the short put contract’s expiration. If the stock price is above the short put, the option will expire worthless. The long put option will be out-of-the-money and have time value remaining. The extrinsic time value will depend on the length of time until expiration and the strike price relative to the stock price.
Time value, or theta, works against the long option, and the contract will lose value exponentially as it approaches expiration. A sell-to-close (STC) order will be entered when the investor wishes to exit the long put position. If the underlying stock price is below the short put at the first expiration date, both options may be closed to exit the position. This will result in the maximum loss on the trade.
If the investor chooses only to close the in-the-money short put option, more risk is possible. The stock could reverse, and the long put option will lose value. However, if the stock price were to decrease, a profit could still be realized.
Time decay impact on a Put Diagonal Spread
Time decay, or theta, will positively impact the front-month short put option and negatively impact the back-month long put option of a put diagonal spread. Typically, the goal is for the short put option to expire out-of-the-money. If the stock price is above the short put at expiration, the contract will expire worthless. The passage of time will help reduce the full value of the short put option.
The time decay impact on the back-month option is not as significant early in the trade, but the theta value will increase rapidly as the second expiration approaches. This may influence the decision related to exiting the position.
Implied volatility impact on a Put Diagonal Spread
Implied volatility has a mixed effect on put diagonal spreads. The bull put spread component of the diagonal spread will be negatively impacted by increased implied volatility while the calendar spread will benefit. Ideally, the front-month short put option will expire out-of-the-money and be unaffected by changes in implied volatility. The position will experience the most profit if volatility is higher at the time of the second expiration. However, the stock price will need to be above the options’ strike price at the first expiration.
If implied volatility increases significantly early in the first expiration, the spread between the two contracts will decline. After the near-term expiration, increased implied volatility helps the position. Higher implied volatility means there is a greater expectation of a large price change, which is ideal for the remaining long put position that is out-of-the-money when the first contract expires.
Adjusting a Put Diagonal Spread
Put diagonal spreads can be adjusted during the trade to add credit. If the underlying stock price increases rapidly before the first expiration date, the short put option can be purchased and sold at a higher strike closer to the stock price. This will collect premium, but the risk increases to the adjusted spread width between the strikes of the near-term expiration contract and long-term expiration contract if the stock reverses. If the short put option expires out-of-the-money, and the investor does not wish to close the long put, a new position may be created by selling another short put option.
The ability to sell a second put contract after the near-term contract expires or is closed is a key component of the put diagonal spread. The spread between the short and long put options would need to be at least the same width to avoid adding risk. Selling a new put option will collect more credit, and may even lead to a risk-free trade with unlimited upside potential if the net credit received is more than the width of the spread between the options.
Rolling a Put Diagonal Spread
The short put option of a put diagonal spread can be rolled higher if the underlying stock price rises. The short put may be purchased and resold at a higher strike price to collect more credit and increase profit potential. Ideally, the stock still closes above the short option, so it expires worthless. The long put option may have extrinsic value remaining to help reduce the loss or potentially make a profit.
Hedging a Put Diagonal Spread
Put diagonal spreads are typically not hedged. The strategy has a specific goal and defined risk. The position may be adjusted higher if the underlying stock price rises. The put diagonal spread holder may do nothing and continue to hold the position, let the near-term contract expire worthless, and see if the underlying security drops during the longer-term expiration. If the near-term contract is closed and a new contract is sold, the long put position may potentially be “free” if the combined credits of the two short contracts exceed the debit required to enter the long put position. The reduced cost of the long put minimizes or eliminates the break-even point on the position.
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