Put Diagonal Spread Options Strategy | TrendSpider Learning Center (2024)

7 mins read

Put diagonal spreads are an advanced options trading strategy that can help traders generate income while managing risk. This strategy involves buying and selling put options with different strike prices and expiration dates. By utilizing this strategy, traders can potentially benefit from both time decay and price movements in the underlying asset.

In this article, we’ll take a closer look at put diagonal spreads, how they work, and some advantages and disadvantages traders should keep in mind before using this strategy.

What Is a Put Diagonal Spread?

A put diagonal spread is an options trading strategy that involves buying a longer-term put option and selling a shorter-term put option at a different strike price. The strategy can be used for both bullish and bearish market scenarios.

In a bullish put diagonal spread:

1. The long put option has a lower strike price than the short put option.
2. The objective is to profit from the underlying asset’s price remaining stable or rising.
3. The trader buys the longer-term put option as a hedge against a potential downside move in the underlying asset.
4. The trader sells the shorter-term put option to collect premium income.

In a bearish put diagonal spread:

1. The long put option has a higher strike price than the short put option.
2. The objective is to profit from the underlying asset’s price remaining stable or falling.
3. The trader buys the longer-term put option as a hedge against a potential upside move in the underlying asset.
4. The trader sells the shorter-term put option to collect premium income.

In both cases, the trader hopes that the short option will expire out of the money, allowing them to keep the premium income. The long put option provides protection in case the market moves against the trader’s position.

The maximum profit potential in a put diagonal spread is limited and occurs when the price of the underlying asset is equal to the strike price of the short put option at expiration. In this case, the short put would expire out of the money and the long put can be sold for its extrinsic value.

The maximum loss potential is the width of the spread minus the credit or plus the debit if the spread is closed at the first expiration date.

The width of a put diagonal spread is the difference between the strike prices of the long and short put options. A wider spread can result in higher maximum profit potential, but also a higher maximum loss potential. A narrower spread can result in lower maximum profit potential, but also a lower maximum loss potential. Traders should choose the width of the spread based on their risk tolerance, market outlook, and overall trading strategy.

Put Diagonal Spread Example

Bullish Put Diagonal Spread Example

Let’s say you’re bullish on a stock XYZ and it’s currently trading at $100 per share. You believe that the stock will increase in price over the next few months, but you also want to limit your potential losses in case your prediction is wrong.

To implement a bullish put diagonal spread, you could do the following:

1. Buy a long-term put option on XYZ with a strike price of $90 and an expiration date 6 months from now. This will protect you against any major downside movements in the stock.
2. At the same time, sell a short-term put option on XYZ with a strike price of $95 and an expiration date 1 month from now. This will generate some income for you upfront and will also give you a chance to profit if the stock remains relatively stable or increases in price.

If the stock price remains relatively stable or increases over the next month, the short-term put option you sold will expire worthless, and you’ll keep the income you generated from selling it. Meanwhile, your long-term put option can be sold for profit.

Bearish Put Diagonal Spread Example

Let’s say you’re bearish on a stock XYZ and it’s currently trading at $100 per share. You believe that the stock will decrease in price over the next few months, but you also want to limit your potential losses in case your prediction is wrong.

To implement a bearish put diagonal spread, you could do the following:

1. Buy a long-term put option on XYZ with a strike price of $110 and an expiration date 6 months from now. This will protect you against any significant upside movements in the stock.
2. At the same time, sell a short-term put option on XYZ with a strike price of $105 and an expiration date 1 month from now. This will generate some income for you upfront and will also give you a chance to profit if the stock remains relatively stable or decreases in price.

If the stock price remains relatively stable or decreases over the next month, the short-term put option you sold will expire worthless, and you’ll keep the income you generated from selling it. Meanwhile, your long-term put option can be sold for profit.

How to Trade a Put Diagonal Spread

Here are the steps to trade a put diagonal spread:

1. Determine your market outlook: Decide whether you are bearish or bullish on the underlying asset that you want to trade. This will help you determine the direction of the spread.
2. Choose your strike prices: Select the strike prices of the put options that you want to trade. For a bullish outlook, the strike price of the long put should be lower than the strike price of the short put. For a bearish outlook, the strike price of the long put should be higher than the strike price of the short put.
3. Choose your expiration dates: The expiration date of the long put option should be further out in time than the expiration date of the short put option.
4. Buy the long put: Buy the longer-term put option with the selected strike price. This is your protection in case the market moves against your position.
5. Sell the short put: Sell the shorter-term put option with the selected strike price. This is where you will collect premium from the sale of the option.
6. Monitor the position: Watch the price movements of the underlying asset and the options closely. As the expiration date of the short put option approaches, you will need to decide whether to close out the position or roll it forward.

Remember to always have a plan in place before entering any trade and be prepared to adjust or exit the position if market conditions change.

How to Adjust a Put Diagonal Spread

Adjusting a put diagonal spread involves making changes to the position to either reduce risk or increase potential profit. Here are some common adjustment strategies for a put diagonal spread:

1. Change the strike prices: If the price of the underlying asset is moving against your position, you may want to adjust the strike prices of your options. For example, if you have a bearish put diagonal spread, you can move the short put to a lower strike price or the long put to a higher strike price to increase your potential profit. Conversely, if you have a bullish put diagonal spread, you can move the short put to a higher strike price or the long put to a lower strike price to increase your potential profit.
2. Adjust the expiration dates: If the price of the underlying asset is not moving as expected, you may want to adjust the expiration dates of your options. For example, if you have a bearish put diagonal spread, you can extend the expiration date of the long put option to give the underlying asset more time to decline in value. Conversely, if you have a bullish put diagonal spread, you can extend the expiration date of the long put option to give the underlying asset more time to appreciate in value.
3. Close out the position: If the price of the underlying asset is moving too far against your position, you may want to close out the position and take a loss. Alternatively, if the price of the underlying asset has moved in your favor and you have realized your profit target, you may want to close out the position and take your profit.

It’s important to note that adjusting a put diagonal spread can be complicated and may require advanced options trading knowledge. You should always consider the potential risks and rewards before making any adjustments to your position.

Pros and Cons of Put Diagonal Spreads

Put diagonal spreads can have both pros and cons for investors, and it’s important to understand them before deciding whether to use this strategy. Here are some potential pros and cons of put diagonal spreads:

Pros:

1. Income generation: One of the primary benefits of put diagonal spreads is that they can generate income for traders through the sale of shorter-term put options. This income can offset the cost of purchasing the longer-term put option and potentially provide a net profit.
2. Time decay: Because put diagonal spreads involve selling shorter-term put options, traders can benefit from time decay as those options lose value over time. This can help increase the profitability of the strategy over the longer term.
3. Limited risk: Unlike some other options trading strategies, put diagonal spreads have limited risk. The maximum loss is typically limited to the width of the spread minus the credit or plus the debit, which provides some downside protection for traders.
4. Flexibility: Traders can adjust the strike prices and expiration dates to suit their market outlook and risk tolerance.

Cons:

1. Limited profit potential: While put diagonal spreads have limited downside risk, they also have limited upside potential.
2. Requires careful timing: Because put diagonal spreads involve buying and selling options with different expiration dates, timing is crucial. If the underlying asset moves too quickly or too slowly, the strategy may not be effective.
3. Complexity: Put diagonal spreads can be a complex strategy, especially for traders who are new to options trading. It requires a thorough understanding of options pricing, volatility, and the interplay between different expiration dates and strike prices.

Put diagonal spreads can be a useful tool for investors looking to generate income while managing risk. However, it’s important to weigh the potential pros and cons carefully and have a solid understanding of options trading before using this strategy.

The Bottom Line

Put diagonal spreads can be a powerful tool for generating income and managing risk in options trading. By buying and selling put options with different strike prices and expiration dates, traders can potentially benefit from both time decay and price movements in the underlying asset. However, as with any options trading strategy, there are risks involved, and traders must carefully consider their goals and risk tolerance before implementing this approach.