diagonal put spreads

OPTIONS STRATEGY LABTRADING STRATEGIES

14 October 2009 • FUTURES & OPTIONS TRADER

BY JOHN SUMMA

Diagonal put spreads:Beyond the basic credit spread

Note: A version of this article originally appeared in the March 2005issue of Active Trader magazine.

A“vertical” credit spread consists of a short out-of-the-money (OTM) call or put option and along call or put that is farther out of the money.“Vertical” refers to the fact that the spread uses

options with the same expiration month. Option spreadsusing different expiration months are sometimes called“horizontal.”

Because you are selling the more expensive option(which is closer to the money) and buying the cheaper one(the more distant option), you are taking in more premiumthan you are spending –– i.e., a “credit” is created in yourtrading account, which is also your maximum potentialprofit on the trade.

During bull markets, option sellers often like to sell ver-tical put credit spreads, a strategy that has worked wellwhen the stock market has either traded higher or side-ways. Although this strategy has good profit potential (andlimited risk), it cannot make more than the credit receivedat the outset of the trade.

However, there is a way to alter a put credit spread thatcreates the potential to make more than the initial credit,and also to profit from rising volatility. Instead of selling avertical spread, you can construct a “diagonal” put spreadby using options with different expiration months.Diagonal credit spreads, especially in low-volatility envi-

ronments such as the one the market was in during much of2004 (which carries the possibility of a sudden volatilityincrease), offer a special edge not available with a conven-tional vertical credit spread.

In the examples that follow, options on S&P 500 futuresare used. They are the most attractive vehicles for stockindex option writers because, among other things, theyoffer more premium bang for the margin buck. Most pro-fessional traders use S&P 500 futures options rather thanOEX or SPX stock index options for selling strategies.

The vertical put credit spreadA standard vertical put credit spread is a popular strategyto profit from time value decay, or theta. The strategy isknown as a bull put spread because it profits from a bullishmove in the underlying instrument. It can also profit if theunderlying remains range-bound or even declines moder-ately.

A bullish move will reduce the position’s value (creatinga profit for the seller) as the underlying market moves far-ther from the options’ strike prices, thus causing the spreadbetween the premiums of the short and long puts to shrink.

On the other hand, in a range-bound or moderatelydeclining underlying market, the spread shrinks because oftheta, which accelerates as expiration approaches. The clos-er the expiration date, the less time premium the optionshave, which reduces the spread and produces a profit(assuming the market has not dropped too far).

Expanding the conventional “vertical” credit spread to incorporate different expiration months

results in a position with enhanced profit potential.

Because you are selling a more expensive option and buyinga cheaper one, the vertical put spread creates a net credit.

TABLE 1 — VERTICAL PUT CREDIT SPREAD

Vertical Strike Premiumput spread price

Long put Dec. 1135 -.80

Short put Dec. 1155 +1.95

Option premium credit = +1.15 ($287.50)

Because the position’s net theta is positive, it means thespread profits from time decay as expiration approaches.

TABLE 2 — PROFITING FROM TIME DECAY

Vertical Strike Thetaput spread price

Long put Dec. 1135 -23.7


Position theta = +44.70

FUTURES & OPTIONS TRADER • October 2009 15

Typically, most S&P 500 futures-option spreaders willwrite options with two to six weeks remaining until expira-tion and strike prices at least one standard deviation fromthe underlying price. These parameters generally providefor the necessities of position management while offeringenough premium relative to transaction costs. However,should the underlying move too far, there is potential forlarge losses if position adjustments are not made.

Table 1 shows an example of a vertical put spread. Withthe December 2004 S&P 500 futures (SPZ04) at 1189.40, thespread consisted of a long December 1135 put and a shortDecember 1155 put for a credit of 1.15, or $287.50. (Eachpoint of S&P 500 option premium is worth $250.) The shortleg of the spread is justless than 35 points out ofthe money, which is justshy of two standard devi-ations. (The hypotheticalposition expired prof-itably on Friday, Dec. 16,2004, 10 trading daysafter they were selected.)At the prevailing volatili-ty levels and distancefrom the money (approx-imately two standarddeviations), this trade hasan expected probabilityof profit of 97 percent.

Table 2 shows the thetavalues for each option inthe spread and under-scores how this strategymakes money. The longDecember 1135 put loses$23.70 in time decay perday but the shortDecember 1155 put gains

$68.40 in time decay per day, which means the spread isprofiting at a rate of $44.70 per day. Because time valuedecays at an accelerating rate, the potential gains increasewith each passing day, all other factors remaining the same.

Because the options can only decline to zero, regardlessof the time decay rate, the maximum profit potential of thestandard vertical put spread is always the initial net credit.Assuming both options remain out of the money, the profitbefore commissions and fees would be $287.50. This is theshortcoming of this strategy –– you can only achieve thisprofit if these options expire worthless, regardless of thevolatility level or underlying price movement.

continued on p. 16

The vertical put credit spread is transformed into a diagonal spread by replacing the December 1135 long putwith a January 1070 long put. Although this reduces thespread’s net credit to .65, it gives the position the ability to generate additional profits.

TABLE 3 — DIAGONAL PUT CREDIT SPREAD

Diagonal Strike Premiumput spread price

Long put Jan. 1070 -1.25


Option premium credit = +.65 ($162.50)

TABLE 4 — DIAGONAL SPREAD THETA

Diagonal Strike Thetaput spread price

Long put Jan. 1070 -17.30


Position theta = +51.10

Because it is more distant from expiration, the longJanuary 1070 put has a much lower theta than the longDecember 1135 put from the vertical spread. As a result,the diagonal spread’s theta has increased to $51.10.

Profit/loss at December

expiration

FIGURE 1 — PROFITABILITY AND PROBABILITY

Source: OptionVue5 Option Analysis Software (www.optionvue.com)

The diagonal put spread has an expected profit of $388, $100 or so more than the original vertical put spread. Also, as you move lower along the price axis, the positions vega increases.

http://www.optionvue.com


If the S&P corrects,say, 1 to 3 percent, as ithas periodically through-out the past few yearssince its bullish move offthe 2002 lows, any mod-est volatility spikes(volatility rises whenequity futures decline)can quickly add value toput options. A diagonalput spread has the abilityto turn these events intopotential profits, while avertical put spreadremains limited to thepremium collected whenthe spread was placed.

Diagonal put creditspreadTable 3 shows how a ver-tical put credit spread istransformed into a diag-onal spread: TheDecember 1135 long puthas been replaced with aJanuary 1070 long put.This has reduced thespread’s net credit to .65($162.50).

However, this smallercredit does not necessari-ly mean less potentialprofit. The diagonalspread is a “time” spread(also known as a calen-dar spread), whichmeans the options expirein different months.Therefore, a time-decaydifferential existsbetween the two options.

Table 4 shows thetheta of the diagonalspread and its compo-nent options. Because ithas more time until expi-

TRADING STRATEGIES

By keeping the original December 1135 long put and adding the long January 1070 put (creating a three-legged vertical-diagonal combination trade), the trade’s margin requirementdrops to $3,800, about $500 below the original put spread’s margin.

FIGURE 3 — ADDING A LEG


If the S&P is at 1160 at expiration (which represents an approximately 3-percent drop fromwhere the index was when the diagonal spread was established), the maximum profit increases to $900 from the original vertical spread’s $287.50 profit. The increased profitoccurs because the January 1070 put can capitalize on both the additional volatility and downside price movement.

FIGURE 2 — RESPONDING TO VOLATILITY


Profit/loss at December

expiration



ration, the long January 1070 put has amuch lower theta than the previouslong December 1135 put, which had atheta of -23.7. As a result, the positiontheta has increased to $51.10 from$44.70, or an additional $17.40 per dayin time decay — this, despite the factthe initial credit received from writingthis spread decreased to $162.50.

Looking at the profit/loss dynamicsof this diagonal put spread in Figure 1,the probability of profit is 98 percent,with an expected profit of $388, $100 orso more than the original vertical putspread.

However, the real advantage ofgoing diagonal comes in the form of an

enhanced ability to profit from avolatility increase, as shown in Figure2. (Both Figures 1 and 2 show at-expi-ration data, which is located below thesolid profit/loss function. The dottedlines represent interim profit/lossperiods.) Figure 1 shows the positionhas turned vega-positive at the expira-tion of the December put, with a posi-tion vega of 57.2 at the current pricelevel.

As we move lower along the priceaxis, the position’s vega increases.What does this mean in terms of volatil-ity changes? Figure 2 simulates a rise inthe entire volatility structure by 3 per-centage points, which would occur

with about a 30-point drop in the S&P500 futures. If the S&P was at 1160 atexpiration (which is an approximately30-point drop from the point this tradewas established), the maximum profitincreases to $900 from the original ver-tical spreads $287.50.

The increased profit results from theJanuary 1070 put capitalizing on theadditional volatility and gaining fromdownside price movement. Because itexpires in January rather than Dec-ember, this option has additional timevalue at the expiration of theDecember short put. If the December1155 short put option expires worth-

continued on p. 18

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less, you can pocket thegain on the long Januaryput.

If you recall, thisspread was establishedfor .65 or $162.50. At theexpiration of theDecember 1155 put (withthe December futures set-tling at 1160), the spreadwill widen to $1,062.50 ––a $900 profit (before com-missions and fees).Although we are assum-ing the January futurescontract trades at thesame premium asDecember futures (thereis typically a stable ratioin equity index futuresduring short-term time

frames, such as the one describedhere), the expected profit with a risein volatility now increases to $626, upfrom the $380 in Figure 1, and upfrom the $287.50 in the verticalspread.

Disadvantages, risks, andanother legMargin requirements are higher(about twice the level of initial marginrequirements) for the diagonal putspread, so the higher expected profitessentially requires equal additionalrisk to obtain.

However, if you keep the originalDecember 1135 long put bought at .80and add the long January 1070 put(creating a three-legged vertical-diag-onal combination trade), the marginrequirement drops to $3,800, about$500 below the vertical put spread’soriginal margin requirement. Figure 3reveals that the expected probabilityof profit remains the same at 98 per-cent, with an expected profit of $258with no volatility change, and $540 inthe event of a three-percent volatility

TRADING STRATEGIES

The expected profit for the revised spread in the event of a three-percent volatility increase is$540.

FIGURE 4 — THREE-LEGGED SPREAD WITH VOLATILITY INCREASE


Profit/loss atDecember expiration

Source: Barclay Hedge (www.barclayhedge.com) Based on estimates of the composite of all

accounts or the fully funded subset method. Does not reflect the performance of any single account.

PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE.

Top 10 option strategy traders ranked by August 2009 return.

(Managing at least $1 million as of Aug. 31, 2009.)

August 2009 YTD $ underRank Trading advisor return return mgmt.

1. CKP Finance Associates (Masters) 15.96% 174.59% 2.0

2. NEOS Advisors (Special Opportunities) 7.88% 8.36% 47.4

3. Washington (Singleton Fund) 7.58% 35.95% 55.7

4. ACE Investment Strat (ASIPC INST) 5.39% 26.08% 1.3

5. LJM Partners (Aggr. Premium Writing) 4.75% 21.20% 26.0

6. ACE Investment Strategists (ASIPC) 4.53% 27.26% 3.6

7. Kingsview Mgmt (Retail) 4.25% 16.00% 3.0

8. ACE Investment Strategists (DPC) 4.19% 64.42% 16.3

9. Oak Investment Group (Ag Options) 4.18% 47.35% 4.4

10. Nantucket Hedge Fund - CTA 3.40% -4.97% 4.4

MANAGED MONEY


http://www.barclayhedge.com

increase (Figure 4). Thus, by leaving in place the origi-

nal December 1135 long put and goingdiagonal with the January 1070 put,the expected $540 profit (with a mod-est correction to 1160) can be obtainedon margin that does not exceed $4,500for this trade. This represents a 12-per-cent profit-to-margin ratio. If theunchanged-volatility expected profit isused, the rate of return on margin is5.7 percent.

For the original vertical creditspread, the return on margin of $4,700(which is the maximum requirementdown to 1160 on the S&P 500) is 6.1percent. While the unchanged-volatil-ity profit on margin is slightly lowerfor the diagonal spread, there is anadditional profit potential of 6 percentfrom a rise in volatility, which morethan compensates for the commissioncosts of the purchase of the additionallong December 1135 put.

Getting more out ofvolatility and time decayThe traditional vertical credit spreadhas limited risk but limited profitpotential as well. However, by con-structing a diagonal put spread, addi-tional profit can be extracted fromtime decay and volatility increases.(But not without an equal increase inrisk.)

But, if you leave the original verticalput spread structure in place and adda January long put to create anotherversion of a diagonal spread (a three-legged vertical-diagonal combinationstrategy), there is a potential jumpfrom 6.1-percent to 12-percent in prof-it on margin. This result stems from ahypothetical increase in volatility aris-ing from a modest correction in theS&P 500.�

For information on the author see p. 6.

Related reading:

“Option spreads: The reinsurance approach”Active Trader, July 2004. An analysis of option credit spreadsfrom the perspective of playing the odds the way insurers and casinos do.

“Timing events with the calendar spread”Active Trader, October 2003. The calendar spread offers a way to capitalize on aspects of time, market direction and volatility.

“Controlling risk with spreads” Active Trader, March 2003. Trading the bull call-option spread.

“Extra credit (spreads)” Active Trader, February 2002. Another look at trading creditspreads.

“Spreading your charting options” Active Trader, July 2000. How to know what strategies areappropriate for different market conditions.

Bob DormanAd sales East Coast and [email protected]

(312) 775-5421

Allison CheeAd sales West Coast and Southwest

[email protected](415) 272-0999

Mark SegerAccount Executive

[email protected](312) 377-9435

Three good tools for targeting customers . . .

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FUTURES & OPTIONS TRADER • October 2009 19

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diagonal put spreads

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