Execute A Diagonal Bear Put Spread – Long Position In Long Term Puts & Sale Of Near Term Puts

Introduction To Diagonal Bear Put Spread

When an options trader buys long term puts while selling near term puts with a lower strike price, that is a diagonal bear put spread. It involves options of different expiration dates.All put options involved are derived from the same underlying security.

A Net Debit

Constructing a diagonal bear put spread will result in a net debit as the long term options cost more than the short term options.

Margin requirement

Executing a diagonal bear put spread requires margin. The amount of margin required is subject to broker’s discretion.

Diagonal bear put spread vs bear put spread

The diagonal bear put spread involves put options with different expiration dates. Bear put spreads however involve options with the same expiration dates.

Time Value Considerations

Time value erosion is detrimental to the long put positions but helpful to short put positions in a diagonal bear put spread.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Assess The Outlook – Short term neutrality to bearishness to a small degree & Long term bearishness
Step 3 :Study the option chain
Step 4 : Understand That Losses Are Limited In A Diagonal Bear Put Spread
Step 5 : Understand That Profit Is Capped
Step 6 : Make It A Point To Calculate Profit
Step 7 : Calculate Risk & Reward Ratio
Step 8 : Set Up Trade : Executing a diagonal bear put spread

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Step 1 : Perform economic, fundamental and technical analysis

The first thing to do is to assess the economy, then the fundamentals and determine a suitable entry point using technical analysis. This is not meant to be exhaustive by any means but hopes to give the audience some general guidance on what to do before executing a diagonal bear put spread. Please read tutorials on economic analysis , fundamental analysis and technical analysis.

Some of the chart patterns that an options trader should look out for is :

Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis

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Step 2 :Assess The Outlook – Short term neutrality to bearishness to a small degree & Long term bearishness

The rationale for buying long term puts is because the trader has a bearish projection on the underlying security in the long term. But in the near term, the trader is neutral to slightly bearish. Hence, the selling of near term lower strike(exercise) put options.

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Step 3 :Study the option chain

Next, the options trader should study the options chain. From the options chain, the options trader can select the options to be used in the diagonal bear put spread. From there, the net debit can also be calculated.

Read :  Learn to read and understand options chain

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Step 4 : Understand That Losses Are Limited In A Diagonal Bear Put Spread

The maximum loss of a diagonal bear put spread is equivalent to the net debit paid when the spread was initiated. The loss occurs when the price of the underlying security is trading at or above the strike(exercise) price of the bought put at expiration of the long term put.

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Step 5 : Understand That Profit Is Capped

The trader who executes the bear put spread can only realise limited profit at any point in time. This is because every long put is accompanied by a short put at a lower strike(exercise) price. But as the short term put expires worthless, the trader can choose to write another short term put. With the ongoing writing of short term puts, the trader collects a regular premium. This allows the trader to effectively reduce the purchase price of the long term put over time. This can happen as long as the price of the underlying security trades between the range of the strike(exercise) prices. Eventually, if the outlook changes to extreme bearishness, the trader can stop writing short term puts and let the long term put capture large downward swings in the price of the underlying security. The eventual profit, when this happens, can be very rewarding. As with all long positions, time value is detrimental to long put only positions. The options trader should be mindful of that.

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Step 6 : Make It A Point To Calculate Profit

The profit from this strategy is equal to the sum of premiums collected added to the difference in the strike prices of the bought put and the sold put less the net debit( net premium paid) of the trade when the trade was executed.

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Step 7 : Calculate Risk & Reward Ratio

Since the net debit is the maximum loss, if a trader is able to estimate the maximum profit, he is able to estimate his risk and reward ratio. The question to ask then is if the trade is worth the risk, compared to other strategies and other executed diagonal bear put spreads based on the trader’s past.

Read  : Understanding Risk/Reward Ratio For Option Traders

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Step 8 : Set Up Trade : Executing a diagonal bear put spread

For every long in the money put, write 1 out of the money put at a lower strike(exercise) price. Since the diagonal bear put spread is a debit spread, a net premium is paid to execute the trade.

Example

ERT Corp is currently trading at a price of $50. A trader believes that the price stock will trade downwards over the next few months. He buys an at the money April 50 put at a price of $3 paying $300 in premium for it. He simultaneously writes an out of the money January 45 put at $1 and collects $100 in premium for it.

On the expiration date of the January 45 put, the trading price of ERT Corp trades at $49 and the January 45 put expires worthless.

He writes another put at a strike(exercise) price of 45. It expires worthless again as the trading price of ERT was $48.50. The written put expires worthless again.

This process is repeated to collect premium.

Until finally, the price of the ERT trades at $46 on the expiration date of the the long April put. Now, the April put has an intrinsic value of $400 as it is $4 in the money. The gain on the April put is $400 – $300 = $100 Along the way from January to April, 4 months of OTM puts were written. Hence since these put expired worthless, $400 was collected from the sold puts. The total profit from the trade is thus:

$400 (premiums collected from short puts) + $100 (gain from long put) = $500

If the price of trades at $53 anc continues going upwards, the long and short options expire worthless and the trader loses : $300 – $100 = $200 which was the net debit to initiate the diagonal bear put spread. As the price goes higher above $50, writing additional puts at a strike(exercise) price of 45 no longer makes sense as the premium collected is very small as it gets further out of the money.

If the price stagnates and stays constant at $50, the long put will expire worthless and since the trader has written 4 months of short puts at strike(exercise) price of 45, $400 is collected from these written puts. Since the long put expired worthless, $300 was lost on the long put. But overall, there is a profit of $400 – $300 = $100

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