DIAGONAL PUT SPREADS
CONTROLLING RISK AND MAXIMIZING RETURNS
Basic Framework - Diagonal Put Spreads:
A diagonal put credit spread strategy is an ideal way to balance risk and reward in options trading. This trade is a modified version of a put credit spread. This strategy involves selling a put option and buying a put option while collecting a credit in the process (see put options explained). When selling the put option, premium is collected and simultaneously using some of that premium income to buy a further dated put option at a lower strike price. The net result will be a credit on the two-leg pair trade with defined risk since the purchase of the put option serves as protection. Diagonal spreads work best when IV Rank is very high.
By selling the put option, you agree to buy shares at the agreed upon price by the agreed upon expiration date. By buying the put option, you have the right to sell shares at the agreed upon price by the agreed upon expiration date. Thus risk is defined and capital requirements are minimal.
Risk is defined since you agree to buy shares at a specific price while also having the right to sell shares at a specific price. If a put option is sold at a strike price of $307.50 and another put option is purchased at a strike of $295 then the max loss is the strike width of $12.50 per share or $1,250 less the net premium received. Since the risk-defined approach has a max loss, the required capital is equivalent to the max loss. If the premium collected was $77 then the required capital would be $1,173 and at expiration of the contact an ROI of 6.5% is obtained for a winning trade (Figure 1).
If the underlying security moves against you and challenges the $307.50 strike then potential losses come into play. Since you have the right to sell shares at a $295 strike, the stock could go to zero and your losses would be capped at $1,175 since you’d be assigned shares at $307.50 and then turn around and sell the shares for $295 per share. The required capital is equal to the maximum loss while the maximum gain is equal to the net option premium income received. Only $1,173 of capital would be required to execute the trade in AAPL (Figure 1).
Figure 1 – Opening a diagonal put spread via selling a put and buying a put while taking in net premium income during the process. Capital requirement is equal to the strike width and risk is defined to maximize return on investment.
Potential Outcomes and Scenarios:
A normal put spread with the same expiration dates will expire together worthless with defined risk. If the option expires between the strikes then losses will incur and if the stock moves below your protection put then max losses will occur at expiration. In a black swan event, clusters of option trades can incur max losses and really jeopardize your profit/loss statement. My goal is limit the losses and not absorb any max losses to optimize risk management.
The further dated put protection leg in a diagonal put spread will allow you to sell-to-close the leg to extract value from the trade if it goes against you. If there's a week left in the further dated option then you still have time premium and if the stock really moves against you then you may have intrinsic value too to partially offset losses. The further dated put protection leg provides more tail end risk mitigation.
Sell a put strike @ $100 10JUL20 and buy a put strike @ $90 17JUL20 to net $100 in premium
A) If the stock stays above $100 at expiration the you net the $100 in premium AND you can sell-to-close the $90 strike for any remaining value to net more than $100 on the trade and capture more than 100% premium capture
B) If the stock trades below $99 then you begin losing money but the $90 strike gains in value and you can sell this $90 strike to offset losses since there's a week left in the contract due to time value. If the stock trades ~$98 at expiration then selling-to-close the further dated put protection will likely circumvent any loss on the trade.
C) If the stock trades below $90 then the $90 strike will gain in value penny for penny below $90 so you can sell this option to avoid any max losses and recapture value from the contract. You would buy-to-close the $100 strike leg to avoid assignment and then sell-to-close the further dated put leg with remaining time value to avoid any max loss situation.
Closing Diagonal Put Spreads:
Managing winning trades is essential so reversing the process via buying-to-close the option leg that was sold-to-open and then selling-to-close the put protection leg that was bought-to-open. This will allow you to close trades early in the option life cycle and capture value that was remaining in the put protection leg. A diagonal put spread was sold on SPY for a net premium credit of $370 and to close out the trade, I bought-to-close the $273 leg that I sold-to-open for a debit of $216.23 and I sold-to-close the $263 protection leg that I bought-to-open for $187.86 (Figure 2).
The net result was premium income of ($370 - (-216.23 + 187.86)) = $342 or an ROI of 6%. The income per contract was $56.90 while the max loss was $943 [($273 - $263) – Premium of $56.90 = $943)].
Figure 2 – Closing both option legs in a diagonal put spread after taking in $370 in premium income and closing the trade for a net debit of $28 to net $342 in income and a 6% ROI on the trade.
Options are a leveraged vehicle thus minimal amounts of capital can be deployed to generate outsized gains with predictable outcomes. A diagonal put credit spread strategy is an ideal way to balance risk and reward in options trading. The COVID-19 black swan event reinforces why appropriate risk management is essential while holding cash on-hand. The overall options-based portfolio strategy is to sell options which enable you to collect premium income in a high-probability manner while generating consistent income for steady portfolio appreciation despite market conditions. This options-based approach provides a margin of safety while mitigating drastic market moves and containing portfolio volatility.
Options trading is a long-term game that requires discipline, patience and time. The COVID-19 black swan event reinforces why keeping liquidity, spreading out expiration dates, maximizing sector exposure, maximizing ticker diversity, risk defining trades and continuing to sell options through all market conditions is essential. Continuing to stick to the fundamentals with defined risk trades via leveraging small amounts of capital to maximize profits is essential. Keeping a significant portion of your portfolio in cash is essential to the overall strategy. Diagonal put spreads offer superior risk mitigation in the event option trades challenge your protection legs.
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