Diagonal Put Spreads

TRADING STRATEGY STRATEGIES OPTIONS LAB

Diagonal put spreads: Beyond the basic credit spread Expanding the conventional “vertical” credit spread to incorporate different expiration months results in a position with enhanced profit potential.

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

“vertical” credit spread consists of a short outof-the-money (OTM) call or put option and a long 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 spreads using 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 premium than you are spending –– i.e., a “credit” is created in your trading account, which is also your maximum potential profit on the trade. During bull markets, option sellers often like to sell vertical put credit spreads, a strategy that has worked well when the stock market has either traded higher or sideways. Although this strategy has good profit potential (and limited risk), it cannot make more than the credit received at the outset of the trade. However, there is a way to alter a put credit spread that creates the potential to make more than the initial credit, and also to profit from rising volatility. Instead of selling a vertical spread, you can construct a “diagonal” put spread by using options with different expiration months. Diagonal credit spreads, especially in low-volatility envi-

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ronments such as the one the market was in during much of 2004 (which carries the possibility of a sudden volatility increase), offer a special edge not available with a conventional vertical credit spread. In the examples that follow, options on S&P 500 futures are used. They are the most attractive vehicles for stock index option writers because, among other things, they offer more premium bang for the margin buck. Most professional traders use S&P 500 futures options rather than OEX or SPX stock index options for selling strategies.

The vertical put credit spread A standard vertical put credit spread is a popular strategy to profit from time value decay, or theta. The strategy is known as a bull put spread because it profits from a bullish move in the underlying instrument. It can also profit if the underlying remains range-bound or even declines moderately. A bullish move will reduce the position’s value (creating a profit for the seller) as the underlying market moves farther from the options’ strike prices, thus causing the spread between the premiums of the short and long puts to shrink. On the other hand, in a range-bound or moderately declining underlying market, the spread shrinks because of theta, which accelerates as expiration approaches. The closer the expiration date, the less time premium the options have, which reduces the spread and produces a profit (assuming the market has not dropped too far).

TABLE 1 — VERTICAL PUT CREDIT SPREAD

TABLE 2 — PROFITING FROM TIME DECAY

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

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

Vertical put spread

Strike price

Premium

Strike price

Theta

Long put

Dec. 1135

-.80

Long put

Dec. 1135

-23.7

Short put

Dec. 1155

+1.95

Short put

Dec. 1155

+68.4

Option premium credit = +1.15 ($287.50)

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Vertical put spread

Position theta = +44.70

October 2009 • FUTURES & OPTIONS TRADER

TABLE 3 — DIAGONAL PUT CREDIT SPREAD

TABLE 4 — DIAGONAL SPREAD THETA

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

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

Diagonal put spread Long put Short put

Diagonal put spread

Strike price

Theta

Strike price

Premium

Jan. 1070

-1.25

Long put

Jan. 1070

-17.30

+1.95

Short put

Dec. 1155

+68.40

Dec. 1155

Option premium credit = +.65 ($162.50)

Position theta = +51.10

Typically, most S&P 500 futures-option spreaders will $68.40 in time decay per day, which means the spread is write options with two to six weeks remaining until expira- profiting at a rate of $44.70 per day. Because time value tion and strike prices at least one standard deviation from decays at an accelerating rate, the potential gains increase the underlying price. These parameters generally provide with each passing day, all other factors remaining the same. for the necessities of position management while offering Because the options can only decline to zero, regardless enough premium relative to transaction costs. However, of the time decay rate, the maximum profit potential of the should the underlying move too far, there is potential for standard vertical put spread is always the initial net credit. large losses if position adjustments are not made. Assuming both options remain out of the money, the profit Table 1 shows an example of a vertical put spread. With before commissions and fees would be $287.50. This is the the December 2004 S&P 500 futures (SPZ04) at 1189.40, the shortcoming of this strategy –– you can only achieve this spread consisted of a long December 1135 put and a short profit if these options expire worthless, regardless of the December 1155 put for a credit of 1.15, or $287.50. (Each volatility level or underlying price movement. continued on p. 16 point of S&P 500 option premium is worth $250.) The short leg of the spread is just less than 35 points out of FIGURE 1 — PROFITABILITY AND PROBABILITY the money, which is just The diagonal put spread has an expected profit of $388, $100 or so more than the original shy of two standard devivertical put spread. Also, as you move lower along the price axis, the positions vega increases. ations. (The hypothetical position expired profitably on Friday, Dec. 16, 2004, 10 trading days after they were selected.) Profit/loss at December At the prevailing volatiliexpiration ty levels and distance from the money (approximately two standard deviations), this trade has an expected probability of profit of 97 percent. Table 2 shows the theta values for each option in the spread and underscores how this strategy makes money. The long December 1135 put loses $23.70 in time decay per day but the short Source: OptionVue5 Option Analysis Software (www.optionvue.com) December 1155 put gains FUTURES & OPTIONS TRADER • October 2009

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TRADING STRATEGIES

FIGURE 2 — RESPONDING TO VOLATILITY If the S&P is at 1160 at expiration (which represents an approximately 3-percent drop from where 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 profit occurs because the January 1070 put can capitalize on both the additional volatility and downside price movement.

Profit/loss at December expiration

If the S&P corrects, say, 1 to 3 percent, as it has periodically throughout the past few years since its bullish move off the 2002 lows, any modest volatility spikes (volatility rises when equity futures decline) can quickly add value to put options. A diagonal put spread has the ability to turn these events into potential profits, while a vertical put spread remains limited to the premium collected when the spread was placed.

Diagonal put credit spread Source: OptionVue5 Option Analysis Software (www.optionvue.com)

FIGURE 3 — ADDING A LEG 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 requirement drops to $3,800, about $500 below the original put spread’s margin.

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

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Table 3 shows how a vertical put credit spread is transformed into a diagonal spread: The December 1135 long put has been replaced with a January 1070 long put. This has reduced the spread’s net credit to .65 ($162.50). However, this smaller credit does not necessarily mean less potential profit. The diagonal spread is a “time” spread (also known as a calendar spread), which means the options expire in different months. Therefore, a time-decay differential exists between the two options. Table 4 shows the theta of the diagonal spread and its component options. Because it has more time until expi-

October 2009 • FUTURES & OPTIONS TRADER

ration, the long January 1070 put has a much lower theta than the previous long December 1135 put, which had a theta of -23.7. As a result, the position theta has increased to $51.10 from $44.70, or an additional $17.40 per day in time decay — this, despite the fact the initial credit received from writing this spread decreased to $162.50. Looking at the profit/loss dynamics of this diagonal put spread in Figure 1, the probability of profit is 98 percent, with an expected profit of $388, $100 or so more than the original vertical put spread. However, the real advantage of going diagonal comes in the form of an

enhanced ability to profit from a volatility increase, as shown in Figure 2. (Both Figures 1 and 2 show at-expiration data, which is located below the solid profit/loss function. The dotted lines represent interim profit/loss periods.) Figure 1 shows the position has turned vega-positive at the expiration of the December put, with a position vega of 57.2 at the current price level. As we move lower along the price axis, the position’s vega increases. What does this mean in terms of volatility changes? Figure 2 simulates a rise in the entire volatility structure by 3 percentage points, which would occur

with about a 30-point drop in the S&P 500 futures. If the S&P was at 1160 at expiration (which is an approximately 30-point drop from the point this trade was established), the maximum profit increases to $900 from the original vertical spreads $287.50. The increased profit results from the January 1070 put capitalizing on the additional volatility and gaining from downside price movement. Because it expires in January rather than December, this option has additional time value at the expiration of the December short put. If the December 1155 short put option expires worthcontinued on p. 18

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FIGURE 4 — THREE-LEGGED SPREAD WITH VOLATILITY INCREASE The expected profit for the revised spread in the event of a three-percent volatility increase is $540.

Profit/loss at December expiration

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

MANAGED MONEY Top 10 option strategy traders ranked by August 2009 return. (Managing at least $1 million as of Aug. 31, 2009.)

August return

2009 YTD return

$ under 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

-4.97%

4.4

Rank Trading advisor

10. Nantucket Hedge Fund - CTA

3.40%

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.

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less, you can pocket the gain on the long January put. If you recall, this spread was established for .65 or $162.50. At the expiration of the December 1155 put (with the December futures settling at 1160), the spread will widen to $1,062.50 –– a $900 profit (before commissions and fees). Although we are assuming the January futures contract trades at the same premium as December futures (there is typically a stable ratio in equity index futures during short-term time frames, such as the one described here), the expected profit with a rise in volatility now increases to $626, up from the $380 in Figure 1, and up from the $287.50 in the vertical spread.

Disadvantages, risks, and another leg Margin requirements are higher (about twice the level of initial margin requirements) for the diagonal put spread, so the higher expected profit essentially requires equal additional risk to obtain. However, if you keep the original December 1135 long put bought at .80 and add the long January 1070 put (creating a three-legged vertical-diagonal combination trade), the margin requirement drops to $3,800, about $500 below the vertical put spread’s original margin requirement. Figure 3 reveals that the expected probability of profit remains the same at 98 percent, with an expected profit of $258 with no volatility change, and $540 in the event of a three-percent volatility October 2009 • FUTURES & OPTIONS TRADER

Related reading:

increase (Figure 4). Thus, by leaving in place the original December 1135 long put and going diagonal with the January 1070 put, the expected $540 profit (with a modest correction to 1160) can be obtained on margin that does not exceed $4,500 for this trade. This represents a 12-percent profit-to-margin ratio. If the unchanged-volatility expected profit is used, the rate of return on margin is 5.7 percent. For the original vertical credit spread, the return on margin of $4,700 (which is the maximum requirement down to 1160 on the S&P 500) is 6.1 percent. While the unchanged-volatility profit on margin is slightly lower for the diagonal spread, there is an additional profit potential of 6 percent from a rise in volatility, which more than compensates for the commission costs of the purchase of the additional long December 1135 put.

Getting more out of volatility and time decay The traditional vertical credit spread has limited risk but limited profit potential as well. However, by constructing a diagonal put spread, additional profit can be extracted from time decay and volatility increases. (But not without an equal increase in risk.) But, if you leave the original vertical put spread structure in place and add a January long put to create another version of a diagonal spread (a threelegged vertical-diagonal combination strategy), there is a potential jump from 6.1-percent to 12-percent in profit on margin. This result stems from a hypothetical increase in volatility arising from a modest correction in the S&P 500. For information on the author see p. 6.

“Option spreads: The reinsurance approach” Active Trader, July 2004. An analysis of option credit spreads from 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 credit spreads. “Spreading your charting options” Active Trader, July 2000. How to know what strategies are appropriate for different market conditions.

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FUTURES & OPTIONS TRADER • October 2009

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