The diagonal bear put spread strategy involves buying long-term puts and simultaneously writing an equal number of near-month puts of the same underlying stock with a lower strike.
This strategy is typically employed when the options trader is bearish on the underlying stock over the longer term but is neutral to mildly bearish in the near term.
|Diagonal Bear Put Spread Construction|
|Buy 1 Long-Term ITM Put|
Sell 1 Near-Term OTM Put
The ideal situation for the diagonal bear put spread buyer is when the underlying stock price remains unchanged and only goes down and below the strike price of the put sold when the long term put expires. In this scenario, as soon as the near month put expires worthless, the options trader can write another put and repeat this process every month until expiration of the longer term put to reduce the cost of the trade. It may even be possible at some point in time to own the long term put "for free".
Under this ideal situation, maximum profit for the diagonal bear put spread is obtained and is equal to all the premiums collected for writing the near-month puts plus the difference in strike price of the two put options minus the initial debit taken to put on the trade.
The maximum possible loss for the diagonal bear put spread is limited to the initial debit taken to put on the spread. This happens when the stock price goes up and stays up until expiration of the longer term put.
In June, an options trader believes that XYZ stock trading at $40 is going to drop gradually for the next four months. He enters a diagonal bear put spread by buying a OCT 40 put for $300 and writing a JUL 35 put for $100. The net investment required to put on the spread is a debit of $200.
The stock price of XYZ goes down by $1 a month and closes at $36 on expiration date of the long term put. As each near-month put expires, the options trader writes another put of the same strike for $100. In total, another $300 was collected for writing 3 more near month puts. Additionally, with the stock price at $36, the OCT 40 put expires in the money with $400 in intrinsic value. Thus, in total, his profit is $400 (intrinsic value of the OCT 40 put) + $300 (additional premiums collected) - $200 (initial debit) = $500.
If the price of XYZ had risen to $42 and stayed at $42 until October instead, both options expire worthless. The trader will also be unable to write additional puts since they are too far out-of-the-money to bring in significant premiums. Hence, he will lose his entire investment of $200, which is also his maximum possible loss.
Suppose the price of XYZ did not move and remains at $40 until expiration of the long term put, the trader will still profit as the total amount of premium collected is $400 while the OCT 40 put cost $300, resulting in a $100 profit.
Note: While we have covered the use of this strategy with reference to stock options, the diagonal bear put spread is equally applicable using ETF options, index options as well as options on futures.
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).
The following strategies are similar to the diagonal bear put spread in that they are also bearish strategies that have limited profit potential and limited risk.
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