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Diagonal put

Diagonal Put

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Basics Concepts – Diagonal Put

Diagonal Put

Description - Diagonal Put

  • The Diagonal Put is a variation of a Diagonal Call where you substitute the calls with puts.
  • The bought option is long-term and OTM, and the short option is short-term and ITM.
  • If the stock rises above the higher (short) strike, your short put will expire worthless, and the long put will decrease in value.
  • The long put will reduce in value because it is further OTM and there will have been some time decay, too.
  • Buy a lower strike long-term expiration put.
  • Sell a higher strike shorter term put (say monthly).
Description Diagonal Put

Introduction to Diagonal Put

Outlook

  • With a Diagonal Put, your outlook is bullish.

Rationale

  • To create a net credit trade by buying the longer term OTM put options and selling the ITM put options while creating the same risk profile as a Diagonal Call Spread.

Net Position

  • This is a net credit trade because your bought puts are OTM and therefore cheaper than your short ITM puts.
  • This of course can depend on the strikes that you choose and the different expiration dates that you choose

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, depending on how far ITM it is.

Time Period to Trade

  • You will be safest to choose a long time to expiration with the long put and a shorter time for the short put.

Breakeven Down = Depends on the value of the long Put option at the time of the short call expiration

Breakeven Up = Depends on the value of the long Put option at the time of the short call expiration

Steps to Trading a Diagonal Put

Steps In

  • Try to ensure that the trend is upward or range bound and identify a clear area of support.

Steps Out

  • Manage your position according to the rules defined in your Trading Plan.
  • Reverse the position if the stock trades outside your lower or higher stop loss areas.
  • If the stock rests between the two strike prices, you’ll be exercised, whereupon you must sell the long put and use the proceeds to buy the stock at the higher strike price (and then sell it at the market price).
  • If the stock rises above the higher strike but is still below your higher stop loss, then the short put will expire worthless, and you’ll have the chance to write another put for the following month, though your long put will have reduced in value significantly.

Exiting the trade - Diagonal Put

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 described previously.
  • 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.

Advantages and Disadvantages

Advantages

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

Disadvantages

  • Capped upside if the stock rises.
  • Uncapped downside—you can lose more than your net debit with this strategy.
  • Can lose on the upside if the stock rises significantly.
  • High yield does not necessarily mean a profitable or high probability profitable trade.

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