Neutral- Diagonal Put Explained

Neutral-Diagonal Put Spread Outlook.

Investors enter into a diagonal spread when they predict the stock’s price will become bullish or neutral in the short term. The near-term short-put option strategy gains profit due to an increase in the stock's price of the underlying stock, which is similar to a bull-put spread. On the other hand, the long-put option strategy maintains its value better than the standard bull-put spread since it has an extended time horizon. When an increase in volatility occurs, it adds value to the extended contract premium. Besides, it has the potential to offset any value decline due to an increase in stock price.

The objective of the neutral-diagonal spread strategy is for the underlying stock’s price to close at a higher value than the short-put option during the first expiration date. The short-put option will expire without value, while the long-put option retains extrinsic value. As an investor at that moment, you may decide to close the long-put option or keep holding the position if you predict the stock's reverse. Another option could be to sell another short-put option to get additional credit, creating a traditional spread situation.

How to Set up the Neutral-Diagonal Put Spread?

The diagonal put spread is a blend of a put calendar spread and a bull put credit spread. You will create a diagonal spread by selling to open a put option and then buy-to-open a put option with a low strike price but a future expiration date.

Though neutral-diagonal put spreads are mostly opened for credit, you can also pay a debit. The pricing during entry depends on the spread’s width between two strike prices and the period of the contract's expiration. A larger debit occurs for a tight spread width since the long-option strategy is closer to money and exhibits more value. The extended time up to the expiration date leads to more costly options pricing, affecting the opening position for credit or debit.

The maximum risk for an investor is equal to the spread’s width minus initial credit. But that depends on whether the short-put option will be in the money and the two options close at the front month's expiration. An investor can sell a long-put due to its intrinsic value when the short-put expires out of the money. After selling long-put plus the original credit, the credit you get becomes your realised profit. If the short put option expires valueless and the underlying stock's price drops, the profit potential becomes unlimited.

How to Exit a Neutral-Diagonal Put Spread?

If the stock’s price is higher than the short-put option, the option expires valueless. Then, the long-put option becomes out-of-money and retains the time value. The extrinsic time-value depends on time length, expiration date and strike price to the stock's price.

The neutral-diagonal spread options involve replacing options contracts with near expiration term dates and purchasing a similar number of contracts with later expiration dates and at different strike prices. The contract of the sold and bought is the same type-calls or puts. The initial purpose of the spread is to earn a premium from sold options.

On the other hand, the bought options that bear a later expiration date offer security against unexpected stock price changes and future potential profits. Therefore, traders close a neutral-diagonal put spread earlier in case the near-month option gets into the money.

There are different ways to exit the diagonal put option. The first option is entering a buy-to-close order for your initially sold near-expiration options. After that, the contract indicates a short holding from the brokerage position screen. You must enter a buy order that closes the short holding position. Due to margin requirements, you need first to close the short-side on the trading options spread.

Evaluating possible profits from a long option spread position with a later expiration period is another way to exit a neutral-diagonal put. Long option trading earns a profit when the underlying stock changes in the right direction. That means the calls go up while the drops are in the money by expiration. When the diagonal's front leg closes, the leg that remains has a lower risk of a long call or a put position.

Effect of Time-Decay on Neutral-Diagonal Put Spread

The time decay harms the back-month long put trading option and a positive result on the front-month short-put trading option. The objective is for the short-put option to reach expiration out-of-the-money. The contract is valueless when the stock's price goes beyond the short-put at the expiry time. The time passage reduces the full worth of the short-put option.

The effect of time-decay on the back-month trading option isn't much during the early times in the trade. However, the theta price increases rapidly when the second expiry time approaches. Therefore, the increasing theta’s value may influence the decision connected to exiting the position.

How Implied Volatility Affects Neutral-Diagonal Put Spread?

The implied volatility displays a blend of impacts on the neutral-diagonal put spreads. The bull spread, which is the diagonal's spread component, is negatively affected by the rise in implied volatility. However, an increase in implied volatility benefits the calendar spread component. Therefore, the put diagonal position earns bigger profits when volatility increases during the second expiration period. But the stock's prices need to remain above the option's strike price during the first expiration for the gains to be realised.

If the implied volatility experiences a sharp increase during the early time of the first expiration, then the spread between the two contracts declines. On the other hand, an increase in implied volatility after near term expiration helps the position. High implied volatility is an indication that a significant price change is expected, which is suitable for the long-put position out of money by the time the first contract reaches expiration.

Example of neural-diamond put strategy

A strategy table

Advantages of neutral-Diagonal put

• An increase in volatility increases the value of the diagonal put spread
• Time decay works in favour of this structure
• The diagonal put trading option allows investors multiple choices to decide at expiration.

Disadvantages of Diamond Put Strategy

• Require investors to have huge capital since premiums are paid upfront
• Early assignments are possible in neutral-diamond put

Risk of Neutral-diamond put

Diamond put strategy has expiration risk. The biggest concern with the diamond put trading option is what would happen at expiration, which the investor may not have control over. When a shorted date is exercised at expiry, the long-term put option remains and offers a hedge. If the longer-dated option helps with the expiry time, a trader has control of the exercises decision.

Summary

Neutral-diagonal put spread gives traders a chance to establish a trade with reduced time effects as they take advantage of a bullish or bearing position, which makes it an excellent strategy to consider. The diagonal put spread can be re-established if the near-term option reaches expiry.

As an investor, one only needs to sell a short option with later expiration data, which allows the trader to earn profits. Neural-diagonal is a good strategy for gaining profits from stagnant stock and obtaining great returns when the stock moderately decreases.