Short Diagonal Calendar Put Spread

How Does Short Diagonal Calendar Put Spread Work in Options Trading?

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Short Diagonal Calendar Put Spread - Introduction

The Short Diagonal Calendar Put Spread, also known as the Short Calendar Diagonal Put Spread, is a volatile options strategy that profits when the underlying stock breaks out either to upside or downside.

It produces its maximum profit potential when the stock breaks out to upside which makes it more preferrable to its close cousin, the Short Horizontal Calendar Put Spread, if the underlying stock has a greater chance of breaking out to upside. The Short Diagonal Calendar Put Spread also has a higher maximum profit potential than maximum loss potential, putting the risk/reward balance in your favor. As a credit spread, however, margin would be required.

This tutorial shall cover all aspects of the Short Diagonal Calendar Put Spread including calculations, advantages and disadvantages.

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Types of Calendar Call Spreads

The Short Diagonal Calendar Put Spread is one of two types of short calendar spreads utilizing only Put options. The other one is the Short Horizontal Calendar Put Spread which produces an equal maximum profit no matter which direction the underlying stock breaks out.

Differences Between Short Diagonal Calendar Put Spread and Short Horizontal Calendar Put Spread

The main difference between the Short Diagonal Calendar Put Spread and the Short Horizontal Calendar Put Spread is that instead of buying short term at the money put options, the Short Diagonal Calendar Put Spread buys out of the money put options. Due to the fact that cheaper out of the money put options are bought, the maximum profit potential of the Short Diagonal Calendar Put Spread is higher than the Short Horizontal Calendar Put Spread as lesser premium is wasted on the short term options. However, that also created an assymetric risk profile with maximum profit achieved only when the underlying stock breaks out to upside. So, if stock is expected to breakout with a higher probability to upside, profit would be better maximised using the Short Diagonal Calendar Put Spread instead of the Short Horizontal Calendar Put Spread.

When To Use Short Diagonal Calendar Put Spread?

Short Diagonal Calendar Put Spreads are used to profit from stocks that are expected to break out with a higher probability of breaking out to downside.

How To Use Short Diagonal Calendar Put Spread?

In a Short Diagonal Calendar Put Spread, at the money (ATM) long term puts are written and then Out of The Money (OTM) near term put options are bought.

Sell Long Term ATM Put + Buy Short Term OTM Put

Short Diagonal Calendar Put Spread Example Assuming QQQQ trading at $45 now. Sell To Open 10 contracts of QQQQ Jan 2008 $45 Put options at $4.70. Buy To Open 10 contracts of QQQQ Jan 2007 $44 Put at $0.50. Net Credit = $4.70 - $0.50 = $4.20

Profit Potential of Short Diagonal Calendar Put Spread :

The Diagonal Short Diagonal Calendar Put Spread makes its maximum profit potential when the stock breaks out to upside to the extent where the extrinsic value of the long term put options are totally diminished.

Profit Calculation of Short Diagonal Calendar Put Spread:

Maximum profit = net credit

Maximum loss occurs when the underlying stock falls to the strike price of the out of the money long put options. When that happens, the long term short put options gain in intrinsic value without a corresponding gain in value on the short term long put options, incurring a greater loss than if the stock remained stagnant.

Short Diagonal Calendar Put Spread makes its maximum profit when the underlying stock breaks out upwards, removing the premium on all the options involved, resulting in the net credit being the maximum profit less any residual value on the long term options.

Short Diagonal Calendar Put Spread Example Assuming QQQQ closes at $50 upon expiration of the short term put options. The 10 contracts of QQQQ Jan 2008 $45 Put options are now trading at $0.01. The 10 contracts of QQQQ Jan 2007 $44 Put expired worthless. Net Profit = $4.20 - $0.01 = $4.19

The Short Diagonal Calendar Put Spread makes a smaller profit when the underlying stock breaks out downwards.

Short Diagonal Calendar Put Spread Example Assuming QQQQ closes at $40 upon expiration of the short term put options. The 10 contracts of QQQQ Jan 2008 $45 put options are now trading at $5.01. The 10 contracts of QQQQ Jan 2007 $44 put are now trading at $4.00. Position value = $5.01 - $4.00 = $1.01 credit Net Profit = $4.20 - $1.01 = $3.19

As you can see from the above calculations, the Short Diagonal Calendar Put Spread makes a higher profit than the Short Horizontal Calendar Call Spread when the underlying stock breaks out upwards but lower profit when the stock breaks out downwards.

Short Diagonal Calendar Put Spread Loss Example Assuming QQQQ closes at $44 upon expiration of the short term put options. The 10 contracts of QQQQ Jan 2008 $45 put options are now trading at $5.20. The 10 contracts of QQQQ Jan 2007 $44 put expired worthless. Net Loss = ($5.50 - $4.70) + $0.50 = $0.80 + $0.50 = $1.30

As you can see above, the maximum profit is much higher than the maximum loss, putting the odds in your favor.

Risk / Reward of Short Diagonal Calendar Put Spread:

Maximum Profit: Limited

Maximum Loss: Limited

Short Diagonal Calendar Put Spread Breakeven Calculation:

The breakeven point of a Short Diagonal Calendar Put Spread is the point below and above which the position will start to make a profit and can only be calculated using the Black-Scholes model.

Advantages Of Short Diagonal Calendar Put Spread:

Higher profit can be attained when the stock breaks out to upside.

Losses are limited.

Disadvantages Of Short Diagonal Calendar Put Spread:

Profits are limited.

Maximum profit lower than Short Horizontal Put Time Spread if stock breaks out to downside.

Margin is needed.

Alternate Actions for Short Diagonal Calendar Put Spreads Before Expiration :

1. The moment the extrinsic value of the long and short term options are almost completely eroded due to a significant breakout, the position should be closed and profit taken. There is no need to hold til expiration because the engine that makes this options trading strategy work is the breakout, not time decay.

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