DESCRIPTION: A diagonal put spread is a combination of a vertical put spread and a short calendar put spread. As a result, it takes on the characteristics of both structures, namely directionally bearish, short volatility with little, no, or even positive time decay depending on the strikes and expirations chosen.
MOTIVATION: The investor wants to take a bearish position in a stock using options, but seeks a strategy that has less time decay than a traditional vertical put spread. Short dated options decay faster than long dated ones. As a result, a diagonal put spread will have less time decay than a vertical put spread. But just like a vertical put spread, the structure uses different strike prices to capture a directional movement.
OUTLOOK: The investor who buys a diagonal put spread believes the share price will fall over the life of the short dated option sold. At expiration, the investor has a number of choices they can make. The can (1) close the trade. (2) If they are still bearish the underlying security, they can hold on to the longer dated put and close the short dated downside put or let it expire worthless. (3) Roll the spread into a new one adjusting the strikes for the current market conditions.
MAXIMUM GAIN: (Higher Strike – Lower Strike) – Premium Paid
The most an investor can make on a diagonal put spread is equal to the difference between the two strikes less the premium paid when putting on the position.
MAXIMUM LOSS: Premium Paid
The maximum loss occurs when the price of the underlying falls so much that the value of the two options effectively goes to zero. Under this scenario, the loss would be the premium paid upfront.
BREAKEVEN: Not well defined
Since the options differ in their time to expiration, the level where the strategy breaks even is a function of the price of the longer dated option at the expiration date of the shorter dated option. In any case, the breakeven would be somewhat below the strike of the higher strike option.
VOLATILITY: Positively correlated. An increase in implied volatility, all other things equal, would have increase the value of a diagonal put spread. Longer dated options have a greater sensitivity to changes in market volatility (vega).
TIME DECAY: Time decay works in favor of the structure. Since shorter dated option decay faster than longer dated ones, the value of a diagonal put spread will decay much slower than a single leg option and can even enjoy price appreciation depending on the differences in the time to expiration and strike prices selected.
ASSIGNMENT RISK: Early assignment is always a possibility with an American style option. If the owner of the short dated option exercises their right to sell stock, the investor in a diagonal put spread will have to sell that stock back in the market or exercise their longer dated put option to liquidate the position.
EXPIRATION RISK: Concerns what happens at expiration, which may not be in the control of the investor. Should the shorted dated put get exercised at expiration, the longer-term put option would still be in place to provide a hedge. If the longer dated option is held to expiration, the investor is in control of the exercise decision.