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What Is A Put Diagonal Ratio Spread?
A Put Diagonal Ratio Spread is a
diagonal ratio spread with the ability to make a profit in all 3 directions;
Upwards, Downwards and Sideways, just like a Put Ratio Spread. Like the Put Ratio Spread, the only way a Put Diagonal Ratio Spread can
lose money is when the underlying stock drops too strongly. That's right, nothing's perfect in options trading. Because the Put Diagonal Ratio Spread loses money only when a stock drops strongly, it has been technically classified as a
neutral options strategy even though it does not lose money no matter how much the underlying stock drops. However, unlike the Put Ratio spread, the same long Put Options can be used
for several months while short term Put Options are written against it so that no additional commission is spent on re-establishing the whole
position month after month. This makes the Put Diagonal Ratio Spread an improved version of the Put Ratio Spread.
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When To Use Put Diagonal Ratio Spread?
Put Diagonal Ratio Spread should be used when you are confident in a drop in the underlying instrument down to a certain price and wishes to make money even if the stock should remain stagnant or go upwards instead. It is a good options trading strategy to maximise profits on stocks that are expected to hit a technical support level and not exceed that level for several months.
How to Execute Put Diagonal Ratio Spreads?
Overview
Put Diagonal Ratio Spreads are established by shorting more near term
out of the money Put Options than the amount of further term in the money /
at the money Put Options are bought, resulting in a credit.
Being a
diagonal spread, Put Options with a longer
expiration are bought while shorter expiration Put Options are shorted. This is the main difference between the Put Diagonal Ratio Spread and the
Put Ratio Spread. In a Put Ratio Spread, both long and short Put Options of the same expiration month are used.
Example of Put Diagonal Ratio Spread:
Assuming QQQQ at $44.
Buy To Open 5 contracts of QQQQ Mar44Put @ $1.55,
Sell To Open 15 contracts of QQQQ Jan43Put @ $0.60
The net effect is, you recieve ($0.60 x 1500) - ($1.55 x 500) = $125 as credit for putting on the position.
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In the above example, 15 contracts of out of the money options are shorted while only 5 contracts of at the money
Put Options are bought. The
ratio in this Put Diagonal Ratio Spread is 3 : 1. This means that for every 1 contract of at the money Put Options bought, 3 contracts of out of the money Put Options are bought. This is why such options trading strategies are known as
Ratio Spreads. Veteran options traders would notice by now that Put Diagonal Ratio Spreads are simply Calendar Put Spreads that sells more out of the money put options than at the money Put Options.
How to Determine Ratio and Strike Price to Use For Put Diagonal Ratio Spread?
Determining the above ratio depends on which strike price the out of the money put options are shorted. In general, the lower the strike price of the out of the money Put Options, the lower the price of each contract and hence the more contracts need to be shorted in order to result in a net credit, requiring higher margin. Because longer term Put Options of the same strike price commands a higher premium, more short term Put Options need to be shorted in a Put Diagonal Ratio Spread than in a Put Ratio Spread of the same strike price, incurring higher options trading margin. This is the main disadvantage of the Put Diagonal Ratio Spread against the Put Ratio Spread.
Example of Different Strike Prices Put Diagonal Ratio Spread:
Assuming QQQQ at $44.
Mar44Put is trading @ $1.55, Jan43Put is trading @ $0.60, Jan42Put is trading @ $0.25.
If the Jan42Put is chosen for shorting instead of the Jan43Put, you would need to short 36 contracts to achieve the net credit of $180
rather than just shorting 15 contracts using the Jan43Put. Below is a comparison:
($0.25 x 3600) - ($1.55 x 500) = $125 credit using the Jan42Put
($0.60 x 1500) - ($1.55 x 500) = $125 credit using the Jan43Put
Note: Each options contract represents 100 shares, therefore the figure used in the calculation is the number of contracts times 10.
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The lower the strike price of the out of the money Put Options shorted in a Put Diagonal Ratio Spread, the lower the stock can drop before the position starts losing money. This is because when the underlying stock drops below the strike price of the short Put Options, the short Put Options start to increase in price faster than the long Put Options. In our above example, if the Jan42Put are shorted, the position starts losing money only when the QQQQ drops below $42 while if the Jan43Put are shorted, the position starts losing money once the QQQQ drops beyond $43. So the trade off here is really the amount of margin you have versus how far you want the losing point to be. the lower the strike price of the out of the money Put Options, the farther the losing point of the Put Diagonal Ratio Spread becomes. Stock options trading is all about trade-offs.
The lower the strike price of the out of the money Put Options shorted in a Put Diagonal Ratio Spread, the higher the maximum profit attainable by the Put Diagonal Ratio Spread will be if the initial net credit is kept the same. However, that also means that the stock needs to drop more in order to attain that maximum profit as the maximum profit attainable by a Put Diagonal Ratio Spread is when the stock closes on the strike price of the short put options upon expiration. Yes, another options trading trade-off.
In an ideal options trading world where margin is not a concern, you would short as many out of the money Put Options as you want to as far out of the money as possible in order to build a Put Diagonal Ratio Spread with the highest possible net credit, maximum profit and farthest losing point. However, such a world does not exist in options trading and margin is as big concern a in Put Diagonal Ratio Spreads as it is in any options trading strategies involving uncovered short option positions.
If you only have enough margin to short a certain number of options contracts, you can either short a higher strike price or you can buy fewer at the money Put Options in order to maintain the net credit in the Put Diagonal Ratio Spread. In our Put Diagonal Ratio Spread examples so far, if you have enough options trading margin to short only 15 contracts, you can use a higher strike price in order to maintain the net credit of the Put Diagonal Ratio Spread position by choosing the Jan43Put and not the Jan42Put as 36 contracts of Jan42Put would not result in a net credit. Otherwise, you can buy no more than 3 contracts of Jan44Putand still maintain a net credit with 15 contracts of Jan42Put. Such is the flexibility of options trading.
Example of shorting a higher strike price and buying lesser Put Options in Put Diagonal Ratio Spread:
Assuming QQQQ at $44 and you have enough margin to short only 15 contracts max.
Jan44Put is trading @ $1.05, Jan43Put is trading @ $0.60, Jan42Put is trading @ $0.25.
Scenario 1: Shorting a Higher Strike.
If you can only short 15 contracts of Jan42Put, you won't be able to cover the price of the 5 contracts of Jan44Putbought at all.
5 Contracts of Jan44Put= $1.05 x 500 = $525. 15 contracts of Jan42Put = $0.25 x 1500 = $375. The position would be a net debit of $150 instead of a net credit. When a Put Diagonal Ratio Spread is a net debit position, it would not be able to make any money if the stock goes down. In this case, you should short the Jan43Puts instead as illustrated in the first example in the overview above.
Scenario 2: Buying lesser Put Options.
In order to maintain a net credit while shorting 15 contracts of Jan42Put, you should buy no more than 3 contracts of Jan44Put .
15 contracts of Jan42Put = $0.25 x 1500 = $375
3 contracts of Jan44Put= $1.05 x 300 = $315
Net Credit = $375 - $315 = $60
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Profit Potential of Put Diagonal Ratio Spread :
The maximum profit potential of a Put Diagonal Ratio Spread is attained when the underlying stock closes at the strike price of the short put options.
In this respect, the profit potential of a Put Diagonal Ratio Spread is limited.
Maximum profit point of Put Diagonal Ratio Spread:
Assuming QQQQ at $44.
Buy To Open 5 contracts of QQQQ Jan44Put@ $1.05,
Sell To Open 15 contracts of QQQQ Jan43Put @ $0.60
Maximum Profit happens when the QQQQ closes at $43 at expiration of the Jan43Put.
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Risk / Reward of Put Diagonal Ratio Spread:
Maximum Profit: Limited
Maximum Loss: Unlimited
Position starts losing money if the stock drops past the strike price of the short Put Options. However, if the stock rises instead of
drops, then the position makes in profit the net credit gained.
Advantages Of Put Diagonal Ratio Spread :
3-way options trading profit.
Much higher profit can be made than a Bear Put Spread when the underlying stock closes at the strike price of the short Put Options.
Put Options can be written against the long Put Options for more than just one month.
Disadvantages Of Put Diagonal Ratio Spread :
Some brokers may not allow beginners to execute such options trading strategies.
Margin is required.
More Margin is required than Put Ratio Spread as more options need to be shorted in order to maintain a net credit at the same strike prices.
Alternate Actions Before Expiration :
1. When the underlying stock reaches the strike price of the short Put Options before expiration, one may choose to
buy to close the
extra short Put Options in order to prevent losses due to a drop in price past breakeven.
2. If the underlying stock has exceeded the strike price of the short Put Options but is expected to correct back up above the strike price of the short Put Options in the following month, you could roll forward the short Put Options into the following month in order to anticipate the pullup. This is a flexibility you will not get in a Put Ratio Spread.
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