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Diagonal Put Spread

 

Description

 

This trade is a combination of a Bear Put Spread and a Put Calendar Spread.

Buy at-the-money (higher strike price) put with 60 days or greater to expiration.

Sell out-of-the-money (lower strike price) put with at least 30 days until expiration

and at least 30 days less until expiration than purchased put.

 

Market Opinion

 

Bullish.

 

P/L

 

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When To Use

 

Use this strategy when you are in a bullish environment and want to generate income.

 

Example

 

XXXX is trading at $26 on May 10, 2011. There is normally 40% volatility associated with the stock.

Buy January 2013 25 puts at $4.00.

Sell June 2011 27.50 puts at $2.20.

 

Benefit

 

With this strategy you can generate monthly income, benefiting from range bound stocks.

 

Risk vs. Reward

 

The risk is that there is uncapped downside, and can lose on the upside if the stock price increases. The reward is monthly income and a higher yield than if you had used a naked put or covered call.

 

Net Upside

 

It depends on the value of the long put when the short put expires.

 

Net Downside

 

Higher strike minus maximum long put value at first expiration minus net credit.

 

Break Even Point

 

It depends on the value of the long put when the short put expires.

 

Effect Of Volatility

 

N/A

 

Effect Of Time Decay

 

Negative for the long put over time. Decays the value of the short put faster, according to how in-the-money it is.

 

Alternatives Before Expiration

 

If the stock trades outside the higher or lower stop loss zones, you can reverse your position.

 

If the stock goes higher than the higher strike yet is under your higher stop loss, then your short put expires without value. You can then write another put for the next month. In the meantime, the long put has reduced in value.

 

Close out position if it drops to 60% of purchase price.

 

Alternatives After Expiration

 

If the stock is between both strike prices, you will be exercised. Sell the long put and by the stock at the higher strike price, then sell it at market price.

 

 

 

 

 

 

 

 
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