A diagonal call spread can be structured to profit from either an increase or decrease in the underlying security price. The ideal situation for the diagonal bear put spread buyer is when the underlying stock price remains unchanged and only goes down and below the strike price of the put sold when the long term put expires. View all Advisory disclosures, Foreign exchange (Forex) products and services are offered to self-directed investors through Ally Invest Forex LLC. The opposite is true if implied volatility drops 1% – the position would lose $6. The position is somewhat similar to a long calendar spread with puts.The ideas is that we want to sell upside puts, but still keep ourselves safe in case the stock has a sharp drop. But there are many ways to profit from this. In our BA example, the maximum gain is estimated at just over $1,300. This means that, all else being equal, the trade will gain $13 per day due to time decay. The greater the spread between the strikes, the wider the range of profitability. After closing the front-month put with strike B and selling another put with strike B that has the same expiration as the back-month put with strike A, time decay is somewhat neutral. NOTE: You can’t precisely calculate potential profit at initiation, because it depends on the premium received for the sale of the second put at a later date. CHAPTER 17 Diagonal Spreads. To reduce assignment risk consider closing your trade if short put is close to being in-the-money, particularly if it is close to expiry. By August 13th, NFLX had dropped to 481.71 and the trade was in profit to the tune of $126 or about 3.88%. Here’s what a diagonal call spread would look like. It starts out as a time decay play. The main risk with the trade is a sharp drop in the underlying stock early in the trade. There are various relationships of days to expiration, deltas and price that the trader needs to decide between For this reason they should only be placed on stocks the trader thinks might move slightly lower but not too much lower. In other words you want the stock to stay relatively flat, but show a rise in implied volatility (the expectation of future big price moves). The opposite is true if we estimate a 10% drop in volatility, the whole payoff graph has now moved downwards with a maximum potential profit of only $1,150. The second type is where the trader sells a near term out-of-the-money put and then buys a longer-term put that is further out-of-the-money. The setup for this diagonal is as follows: Purchase a long term in-the-money put, 376 days to expiration. If established for a net credit, risk is limited to the difference between strike A and strike B, minus the net credit received. If established for a net debit, risk is limited to the difference between strike A and strike B, plus the net debit paid. There are a lot of ways to do diagonal spreads because of the way they're set up. There are two types of diagonal put spread. Notice that an initial drop to $140 will see the trade in a loss situation, but if that level is reached after about day 14, the trade is actually in profit. Profit is limited to the net credit received for selling both puts with strike B, minus the premium paid for the put with strike A. The Dow has still been unable to regain the important resistance of 11,750 (few points here and there). Notice that the expiration line maximum profit has rises from around $1,300 to over $1,500 and all three of the interim lines have also been lifted up. One way to avoid assignment risk is to trade stocks that don’t pay dividends, or trade indexes that are European style and cannot be exercised early. Forex accounts are held and maintained at GAIN Capital. Diagonal put spreads are a neutral to slightly bullish trade that can handle a move lower in the stock provided the move isn’t too big or too early in the trade. We are not responsible for the products, services, or information you may find or provide there. A Long Put Diagonal Spread is usually used to replicate a covered put position. The rationale behind the diagonal ratio spread is to pay for the longer-term options with the shorter. A Long Put Diagonal Spread is constructed by purchasing a put far out in time, and selling a near term put on a further OTM strike to reduce cost basis. In the BA example above, the strikes are $10 apart and there is one contracts, so that makes a $1,000 potential loss, less the $19 in premium received for a total maximum potential loss of $981. You can mitigate this risk by trading Index options, but they are more expensive. That’s because the back-month put is still open when the front-month put expires. 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