Today, on this page, we shall study the put diagonal options strategy. In this strategy, the risk is defined, and the profit potential is limited. The strategy aims to profit from two factors; the time decay factor and the price rise of the underlying asset.
About Put diagonal strategy:
The strategy has two put options, and based on how they are used, they can be bullish or bearish.
When a trader sells a short put option and buys a long-put option contract, a bullish put diagonal spread is created. This bullish put diagonal spread is the combination of put credit spread and put calendar spread, and traders generally enter this position to receive credit.
The bearish put diagonal spread is also used for debit, but we are focusing on put diagonal today.
The strategy can be successful if the stock price of the underlying-asset is above the short put during the front-month expiry time. The back month's long put option contracts will serve as protection against the market risk and will also help traders in defining the risk of the strategy.
Market outlook of the put diagonal option strategy:
When traders believe that the stock price will be neutral or bullish in the short term, during that time, he utilizes this strategy. The near-term short-put option contracts take advantage of the underlying stock price increase. The main objective here is that the stock should close above the short put option contract at the time of expiry.
The short put contract will expire worthless, while long put contracts still have the intrinsic value left. Traders may close the position or sell additional short put options to bring in some additional credit.
How to set a put diagonal spread option strategy?
As we said before, it is a combination of two options strategies; bull put credit and put calendar. To create this strategy trader has to use the order sell-to-open (STO) put option and buy-to-open (BTO) put option at the low strike price, having the later expiry dates, meaning in this strategy, the expiry dates of the contracts are not the same, they differ, and thus traders use the time decay factor for profiting.
In this strategy, the more time the contract has in expiry, the more expensive that contract will be. The highest loss is defined by the spread's width minus the initial credit if both the option contracts are ITM and are going to expire in the front month. If the short put contract expires worthless and the underlying asset's price falls, the trader will have maximum profit.
How to enter the put diagonal spread strategy?
To enter this strategy trader has to sell-to-open (STO) one short put contract and buy-to-open (BTO) one long put contract at a low strike price at a further expiry.
Suppose a stock is currently traded at ₹50, and the trader believes that the stock will stay above only. In such a case trader can initiate this strategy. Here traders can enter the strategy by selling a put option contract at ₹50 and buying a put option at ₹45, expiring at some later date.
Let us understand the diagram of Put diagonal spread:
The diagram of the strategy depends on the trader's decision to exit the position.
The highest risk on the position is defined at the entry by the spread’s width minus the initial credit received.
If the stock closes below the strike-price of the short put front month expiry, traders have to exit the trade to avoid the assignment.
If the stock price is above the strike-price of the put option contract at the front-month expiry - that's what we need to make the strategy profitable. In that case, the short put contracts will expire worthless, and the long ones will still have extrinsic time value. Here the traders have two options: exit from the strategy or continue holding the contracts.
Considering the above example, the trader sold the put contract at ₹50 and bought a put contract at ₹45, expiring at some later date. By entering this position, traders collect the credit of ₹1, then the highest loss in the front month expiry would be -₹400.
The highest profit will vary based on whether the trader exits the position at the front month expiry or stays till the long contract expires. Whatever the scenario gets, ₹100 received initially will be counted as the profit.
How to exit the put diagonal strategy?
To exit the strategy, traders must reverse their order and use a Sell-to-close order position.
Additional notes on Put diagonal option strategy:
The impact of time decay or theta factor on the front-month short option will be positive.
The impact of time decay or theta factor on the back month long-put option will be negative.
The implied volatility factor will have a mixed positive and negative impact on the position.
Traders can roll the short put diagonals by purchasing the short puts and reselling them at a higher price if the underlying asset's price increases. It will help collect more credit and ultimately increase the overall profit of the position.
So, we have seen how combining the two strategies and taking advantage of the time decay factor by selecting the two different expiry dates of the contracts helps you earn profit and limit your loss. In case you have any questions or doubts, kindly reach us at 8447445815 / 9909978783