Tim Olson
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description, tags
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| A diagonal spread buying a deep ITM put at K1 with TTM T' and selling an OTM put at K2 with shorter TTM T < T', combining directional and time decay benefits. |
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Diagonal Put Spread
Section: 2.21 | Asset Class: Options | Type: Income
Overview
The diagonal put spread consists of a long position in a deep ITM put option with strike K1 and TTM T', and a short position in an OTM put option with strike K2 and shorter TTM T < T' (K2 < K1). This is a net debit trade. The trader's outlook is bearish. At t = T let V be the value of the long put (expiring at T') assuming S_T = K2.
Construction
- Buy 1 deep ITM put option at strike K1, TTM T' (longer expiry)
- Sell 1 OTM put option at strike K2, TTM T < T' (shorter expiry, K2 < K1)
Net debit: D
Payoff Profile
At t = T (expiry of short put), let V = value of the long put (expiring at T') assuming S_T = K2:
- P_max = V - D (if S_T = K2 at short expiry)
- L_max = D (net debit paid)
If K2 <= S_T <= S_stop-loss, the trader can write another OTM put with TTM T1 < T'.
Key Conditions / Signals
- Bearish outlook; expects stock to fall toward K2 by the short expiry
- Low volatility environment after entry is ideal for maximizing time decay income
- The deep ITM long put more closely mimics the underlying short stock than an ATM put
Notes
Similar to the calendar put spread but the deep ITM long put (unlike the close to ATM put in the calendar spread) more closely mimics the underlying stock, providing better protection against a sharp drop in the stock price. The trader can generate income by periodically selling OTM put options with shorter maturities.