A diagonal spread with puts is a position made up of buying one long-term put at a higher strike price and selling a shorter-term put at a lower strike price. The position is somewhat similar to a long calendar spread with puts. The ideas is that we want to sell upside puts, but still keep ourselves safe in case the stock has a sharp drop.

diagonal spread with puts

If executed correctly, the trader can continue to sell downside puts against their long further out put. So, when one short-term put expires, the trader can sell another short-term put, set to expire in the following month, and can continue to do this up until the final month, when the long put is set to expire.

Profit/Loss

The maximum profit is calculated by adding up all the premiums received from selling short-term downside puts, minus the initial premium to execute the trade, plus the strike price minus the stock price on the final month.

The maximum loss for a diagonal put spread is limited to the cost of the trade, which is met when the stock trades up above the long-term put strike price.

Breakeven

Because this is a dynamic trade with many possible scenarios and future trades, it is impossible to calculate a breakeven.

Example

If XYZ is trading $100 and is expected to trade lower over the next four months a trader could buy the June 100 put for $4 and then sell the April 95 put for $1.25, resulting in an initial cost of $2.75.

If the stock trades down to $97 by April expiration, then the April put is removed from the account, and the trader has made a gain on the long put. They could then sell a May 95-strike put for $1.75. If the stock trades up to $95 by May expiration, then the trader banks the $1.75 and also has $5 of intrinsic value in the long-term put. They could then sell a June 90 put for $1.25. If the stock trades down to $92 by June expiration, then the June put will also expire worthless. Here the trader would have paid a premium of $2.75 to open the trade, then pocked premiums of  $1.75 and $1.25 along the way. They would also have $8 of intrinsic value in the stock. This would result in a total profit of ($8+$1.75+$1.25-$2.75) = $8.25.

If however, the stock moved higher to $110 after the initial trade, both options would drop too much in value, making moving forward with the strategy impossible. If the stock never traded lower, then both options would expire worthless and the trader would lose his $2.75.

Conclusion

This is more of an advanced strategy that sets to capitalize on short-term higher volatility. It works best if the stock trades down, but slowly over time. That, of course, can be tricky when the strategy is mostly about capturing volatility.

 

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ChrisDouthit
ChrisDouthit

The founder of OptionStrateigesInsider.com has a long history with options and an extensive education in finance. Holding an MBA and multiple finance degrees, Chris has put in the time and effort to learning the market fundamentals.