The Diagonal Put Time Spread, also known as the Put Diagonal Time Spread, is a neutral options strategy that profits from stagnant stocks and reaches maximum profit when the stock goes moderately lower. Like all time spreads, the Diagonal Put Time Spread profits through the difference in time decay between options with longer and shorter expiration. With a long expiration Put Option in place, or a LEAPS Put Option, one Diagonal Put Time Spread can be rolled forward for multiple months. Another advantage of the Diagonal Put Time Spread is that it is a debit spread. Most neutral options strategies are credit spreads which requires margin to put on.
The Diagonal Put Time Spread is one of two types of time spreads that uses only Put options. The other one being the Horizontal Put Time Spread which produces its maximum profit when the underlying stock remains stagnant. Therefore, if the underlying stock is expected to remain stagnant or go down slightly, the Diagonal Put Time Spread would better maximise your profits.
Differences Between Diagonal Put Time Spread and Horizontal Put Time Spread
The Diagonal Put Time Spread has a higher maximum profit potential and a wider profitable range than a Horizontal Put Time Spread. This is due to the fact that the Diagonal Put Time Spread allows the underlying stock some room to move downwards through writing out of the money put options instead of at the money put options. Even though the Diagonal Put Time Spread has a higher maximum profit potential, it actually returns a lower profit than the Horizontal Put Time Spread if the underlying stock remains totally stagnant. This is because the stock needs to move downwards to the strike price of the short Put Options in order for the Diagonal Put Time Spread to produce its maximum profit. The Diagonal Put Time Spread is also more expensive to put on as out of the money Put Options of lesser value than at the money options are written. Such is the kind of trade off in options trading. Because out of the money Put Options are written, Diagonal Put Time Spreads also have an assymetric risk graph which produces its maximum loss (the net debit) only when the stock rises strongly. If the stock falls strongly, the Diagonal Put Time Spread would also produce a much lesser loss than the Horizontal Put Time Spread due to the fact that the long term at the money put options would gain in value faster or in step with the short term out of the money put options. As such, you would use a Diagonal Put Time Spread options trading strategy when a stock is expected to remain within a tight price range and might move moderately lower.
When To Use Diagonal Put Time Spread?
Diagonal Put Time Spreads could be used when you wish to profit from a stock that is expected to stay stagnant or move down slightly for the short term while keeping a long term Put Option position in place in case of future downside breakouts.
How To Use Diagonal Put Time Spread?
In a Diagonal Put Time Spread, Out of The Money (OTM) near term Put Options are written and then at the money (ATM) long term calls are bought.
Buy Long Term ATM Put + Sell Short Term OTM Put
Diagonal Put Time Spread Example Assuming QQQQ trading at $45 now. Buy To Open 10 contracts of QQQQ Jan 2008 $45 Put Options at $4.70. Sell To Open 10 contracts of QQQQ Jan 2007 $44 Put at $0.50.
Net Debit = $4.70 - $0.50 = $4.20
Compare the net debit with the net debit paid for the Horizontal Put Time Spread using at the money options, you would see that the Diagonal Call Time Spread requires more money to put on on the same base strike price.
Profit Potential of Diagonal Put Time Spread :
The Diagonal Diagonal Put Time Spread makes its maximum profit potential when the stock closes at the strike price of the short term Put Options upon expiration of the short term Put Options.
Profit Calculation of Diagonal Put Time Spread:
The value of a Diagonal Put Time Spread during expiration of the short Put Options can only be arrived at using an options pricing model such as the Black-Scholes Model because the expiration value of the long term putl options can only be arrived at using such a model.
Diagonal Put Time Spread Example
Assuming QQQQ closes at $44 upon expiration of the short term Put Options.
The 10 contracts of QQQQ Jan 2008 $45 Put Options is now trading at $5.00.
The 10 contracts of QQQQ Jan 2007 $44 Put expired worthless.
Net Profit = $0.50 (total premium gained from the Jan 2007 $44 Call) + $0.30 (profit on long term Put Options) = $0.80 x 1000 = $800.
From the above example, you can see the huge difference in maximum profit attainable by the Horizontal Put Time Spread and the Diagonal Put Time Spread.
Loss Calculation of Diagonal Put Time Spread:
The Diagonal Put Time Spread makes it maximum possible loss, which is the net debit paid, when the underlying stock rises drastically. In this case, the premium earned from writing the short term Put Options serve as a hedge against the drop in value of the long term Put Options, up to the value of the short term Put Options written.
Conversely, when the underlying stock drops, the out of the money Put Options gain in value only slightly faster than the long term at the money Put Options, resulting in a much lower loss than if the underlying stock falls. This is unlike a horizontal put time spread where maximum loss is the same whether the stock rallies or falls.
Risk / Reward of Diagonal Put Time Spread:
Upside Maximum Profit: Limited
Maximum Loss: Limited
(limited to net debit paid when stock rises strongly)
Diagonal Put Time Spread Breakeven Calculation:
The breakeven point of a Diagonal Put Time Spread is the point below or above which the position will start to lose money if the underlying stock rises or falls strongly and can only be calculated using the Black-Scholes model.
Advantages Of Diagonal Put Time Spread:
Higher profit can be attained when the stock moved moderately lower.
Can be rolled forward for as many months as the expiration month of the long term Put Options.
Options involve risk and are not suitable for all investors.
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