"Profits always take care of themselves, but losses never do."

— Jesse Livermore

What are Put Diagonals?

Put diagonals are an advanced options trading strategy that involves combining a long-term put option with a short-term put option at a different strike price. This strategy is versatile, allowing traders to adjust their positions to fit various market scenarios, especially bearish or sideways trends.

Key Characteristics of Put Diagonals

• Flexibility: You can structure them to benefit from different market conditions.
• Risk Management: Allows you to limit risk while still offering substantial profit potential.
• Cost Reduction: By selling short-term puts, you can offset the cost of your longer-term put, potentially creating a risk-free trade over time.

Setting Up a Long Put Diagonal

A long put diagonal involves:

1. Buying a longer-term put option (e.g., several months or even years until expiration).
2. Selling a shorter-term put option (e.g., a weekly or monthly option).

This creates a position where you can benefit from both the decline in the stock price and the time decay of the shorter-term put.

Example Setup:

• Stock Price: $145
• Long Put Strike: $145 (slightly in the money to minimize time premium costs)
• Cost of Long Put: $4,400
• Short Put Strike: $125 (slightly out of the money)
• Premium from Short Put: $200

How It Works

Initial Position:

• You pay $4,400 for the long-term put.
• You collect $200 by selling the short-term put, reducing the initial cost to $4,200.

Week-by-Week Adjustments:

• Each week, you sell another short-term put to collect additional premium.
• Over time, the premiums collected can "pay down" the cost of the longer-term put.

Possible Scenarios:

1. Stock Price Drops Moderately:
   1. The short-term put loses value as it expires or is bought back.
   2. The long-term put gains value as the stock price drops.
   3. You may choose to hold the long-term put or close both positions for a profit.
2. Stock Price Drops Significantly:
   1. The long-term put sees a significant increase in value.
   2. The short-term put may result in a loss, but the overall position remains profitable.
3. Stock Price Rises:
   1. The short-term put expires worthless, and you keep the premium.
   2. The long-term put loses value, but ongoing short put premiums help offset this.

Managing the Trade

1. Rolling Short-Term Puts:
   1. If the stock price drops significantly, you may roll the short-term put to a lower strike price to capture more premium and adjust the position.
2. Exiting the Position:
   1. If the stock approaches the strike price of the short-term put, consider closing the entire position to avoid assignment or significant loss on the long-term put.
   2. Alternatively, if the long-term put has gained enough value, you can exit with a profit.
3. Risk Mitigation:
   1. Monitor the overall delta of the position to ensure it aligns with your market outlook.
   2. Be cautious of rapid stock movements that can lead to outsized losses on either leg of the diagonal.

A Practical Example

Let’s assume:

• You sold a $125 short-term put for $2 ($200 total premium).
• The stock price drops to $115.

Calculation:

1. The $125 short-term put is now $10 in the money, requiring you to buy it back for $1,000.
2. Your loss on the short-term put is $800 ($1,000 – $200).
3. However, your long-term put, initially purchased for $44/share ($4,400), has increased in value to $50.36/share ($5,036).
4. Overall Profit:

• • Gain on long-term put: $636
  • Loss on short-term put: $800
  • Net Position: –$164

Over time, continued selling of short-term puts can offset such small losses and lead to profitability.

Tips for Success

1. Practice: Use paper trading to refine your understanding of put diagonals and experiment with different scenarios.
2. Adjustments: Be ready to roll or close positions based on changing market conditions.
3. Long-Term Perspective: Focus on reducing the cost of the long-term put while managing short-term risks.
4. Market Outlook: Ensure your outlook aligns with the structure of your diagonal. For example, use a long put diagonal in a bearish or slightly bearish market.

Next Steps

In the next lesson, we’ll explore short diagonals and discuss how to structure these trades for neutral to slightly bullish market scenarios. For now, dive into your trading platform, practice setting up put diagonals, and track how adjustments affect your position over time.

As an additional resource, there is a video covering this entire topic which may include some additional content. Click below to view it.