TRADING STRATEGY
OPTIONS STRATEGIES
LAB
Diagonal put spreads:
Beyond the basic credit spread
Expanding the conventional “vertical” credit spread to incorporate different expiration months
results in a position with enhanced profit potential.
BY JOHN SUMMA
Note: A version of this article originally appeared in the March 2005
issue of Active Trader magazine.
“vertical” credit spread consists of a short out-
A of-the-money (OTM) call or put option and a
long call or put that is farther out of the money.
“Vertical” refers to the fact that the spread uses
options with the same expiration month. Option spreads
using different expiration months are sometimes called
“horizontal.”
Because you are selling the more expensive option
(which is closer to the money) and buying the cheaper one
(the more distant option), you are taking in more premium
than you are spending –– i.e., a “credit” is created in your
trading account, which is also your maximum potential
profit on the trade.
During bull markets, option sellers often like to sell ver-
tical put credit spreads, a strategy that has worked well
when the stock market has either traded higher or side-
ways. Although this strategy has good profit potential (and
limited risk), it cannot make more than the credit received
at the outset of the trade.
However, there is a way to alter a put credit spread that
creates the potential to make more than the initial credit,
and also to profit from rising volatility. Instead of selling a
vertical spread, you can construct a “diagonal” put spread
by using options with different expiration months.
Diagonal credit spreads, especially in low-volatility envi-
TABLE 1 — VERTICAL PUT CREDIT SPREAD
Because you are selling a more expensive option and buying
a cheaper one, the vertical put spread creates a net credit.
Vertical Strike Premium
put spread price
Long put Dec. 1135 -.80
Short put Dec. 1155 +1.95
Option premium credit = +1.15 ($287.50)
14
ronments such as the one the market was in during much of
2004 (which carries the possibility of a sudden volatility
increase), offer a special edge not available with a conven-
tional vertical credit spread.
In the examples that follow, options on S&P 500 futures
are used. They are the most attractive vehicles for stock
index option writers because, among other things, they
offer more premium bang for the margin buck. Most pro-
fessional traders use S&P 500 futures options rather than
OEX or SPX stock index options for selling strategies.
The vertical put credit spread
A standard vertical put credit spread is a popular strategy
to profit from time value decay, or theta. The strategy is
known as a bull put spread because it profits from a bullish
move in the underlying instrument. It can also profit if the
underlying remains range-bound or even declines moder-
ately.
A bullish move will reduce the position’s value (creating
a profit for the seller) as the underlying market moves far-
ther from the options’ strike prices, thus causing the spread
between the premiums of the short and long puts to shrink.
On the other hand, in a range-bound or moderately
declining underlying market, the spread shrinks because of
theta, which accelerates as expiration approaches. The clos-
er the expiration date, the less time premium the options
have, which reduces the spread and produces a profit
(assuming the market has not dropped too far).
TABLE 2 — PROFITING FROM TIME DECAY
Because the position’s net theta is positive, it means the
spread profits from time decay as expiration approaches.
Vertical Strike Theta
put spread price
Long put Dec. 1135 -23.7
Short put Dec. 1155 +68.4
Position theta = +44.70
October 2009 • FUTURES & OPTIONS TRADER
 TABLE 3 — DIAGONAL PUT CREDIT SPREAD
The vertical put credit spread is transformed into a
diagonal spread by replacing the December 1135 long put
with a January 1070 long put. Although this reduces the
spread’s net credit to .65, it gives the position the ability
to generate additional profits.
TABLE 4 — DIAGONAL SPREAD THETA
Because it is more distant from expiration, the long
January 1070 put has a much lower theta than the long
December 1135 put from the vertical spread. As a result,
the diagonal spread’s theta has increased to $51.10.

Diagonal Strike Premium Diagonal Strike Theta

put spread price put spread price
Long put Jan. 1070 -1.25 Long put Jan. 1070 -17.30
Short put Dec. 1155 +1.95 Short put Dec. 1155 +68.40
Option premium credit = +.65 ($162.50) Position theta = +51.10

Typically, most S&P 500 futures-option spreaders will $68.40 in time decay per day, which means the spread is
write options with two to six weeks remaining until expira- profiting at a rate of $44.70 per day. Because time value
tion and strike prices at least one standard deviation from decays at an accelerating rate, the potential gains increase
the underlying price. These parameters generally provide with each passing day, all other factors remaining the same.
for the necessities of position management while offering Because the options can only decline to zero, regardless
enough premium relative to transaction costs. However, of the time decay rate, the maximum profit potential of the
should the underlying move too far, there is potential for standard vertical put spread is always the initial net credit.
large losses if position adjustments are not made. Assuming both options remain out of the money, the profit
Table 1 shows an example of a vertical put spread. With before commissions and fees would be $287.50. This is the
the December 2004 S&P 500 futures (SPZ04) at 1189.40, the shortcoming of this strategy –– you can only achieve this
spread consisted of a long December 1135 put and a short profit if these options expire worthless, regardless of the
December 1155 put for a credit of 1.15, or $287.50. (Each volatility level or underlying price movement.
point of S&P 500 option premium is worth $250.) The short continued on p. 16
leg of the spread is just
less than 35 points out of FIGURE 1 — PROFITABILITY AND PROBABILITY
the money, which is just
shy of two standard devi- The diagonal put spread has an expected profit of $388, $100 or so more than the original
vertical put spread. Also, as you move lower along the price axis, the positions vega increases.
ations. (The hypothetical
position expired prof-
itably on Friday, Dec. 16,
2004, 10 trading days
after they were selected.) Profit/loss
At the prevailing volatili- at December
ty levels and distance expiration
from the money (approx-
imately two standard
deviations), this trade has
an expected probability
of profit of 97 percent.
Table 2 shows the theta
values for each option in
the spread and under-
scores how this strategy
makes money. The long
December 1135 put loses
$23.70 in time decay per
day but the short Source: OptionVue5 Option Analysis Software (www.optionvue.com)
December 1155 put gains

FUTURES & OPTIONS TRADER • October 2009 15

 TRADING STRATEGIES

FIGURE 2 — RESPONDING TO VOLATILITY

If the S&P is at 1160 at expiration (which represents an approximately 3-percent drop from
where the index was when the diagonal spread was established), the maximum profit
increases to $900 from the original vertical spread’s $287.50 profit. The increased profit If the S&P corrects,
occurs because the January 1070 put can capitalize on both the additional volatility and say, 1 to 3 percent, as it
downside price movement. has periodically through-
out the past few years
since its bullish move off
the 2002 lows, any mod-
est volatility spikes
Profit/loss
(volatility rises when
at December
expiration equity futures decline)
can quickly add value to
put options. A diagonal
put spread has the ability
to turn these events into
potential profits, while a
vertical put spread
remains limited to the
premium collected when
the spread was placed.

Diagonal put credit

spread
Source: OptionVue5 Option Analysis Software (www.optionvue.com)
Table 3 shows how a ver-
tical put credit spread is
FIGURE 3 — ADDING A LEG transformed into a diag-
onal spread: The
By keeping the original December 1135 long put and adding the long January 1070 put December 1135 long put
(creating a three-legged vertical-diagonal combination trade), the trade’s margin requirement has been replaced with a
drops to $3,800, about $500 below the original put spread’s margin.
January 1070 long put.
This has reduced the
spread’s net credit to .65
($162.50).
However, this smaller
credit does not necessari-
ly mean less potential
profit. The diagonal
spread is a “time” spread
(also known as a calen-
dar spread), which
means the options expire
in different months.
Therefore, a time-decay
differential exists
between the two options.
Table 4 shows the
theta of the diagonal
spread and its compo-
nent options. Because it
Source: OptionVue5 Option Analysis Software (www.optionvue.com)
has more time until expi-

16 October 2009 • FUTURES & OPTIONS TRADER

ration, the long January 1070 put has a
much lower theta than the previous
long December 1135 put, which had a
theta of -23.7. As a result, the position
theta has increased to $51.10 from
$44.70, or an additional $17.40 per day
in time decay — this, despite the fact
the initial credit received from writing
this spread decreased to $162.50.
Looking at the profit/loss dynamics
of this diagonal put spread in Figure 1,
the probability of profit is 98 percent,
with an expected profit of $388, $100 or
so more than the original vertical put
spread.
However, the real advantage of
going diagonal comes in the form of an
enhanced ability to profit from a
volatility increase, as shown in Figure
2. (Both Figures 1 and 2 show at-expi-
ration data, which is located below the
solid profit/loss function. The dotted
lines represent interim profit/loss
periods.) Figure 1 shows the position
has turned vega-positive at the expira-
tion of the December put, with a posi-
tion vega of 57.2 at the current price
level.
As we move lower along the price
axis, the position’s vega increases.
What does this mean in terms of volatil-
ity changes? Figure 2 simulates a rise in
the entire volatility structure by 3 per-
centage points, which would occur
with about a 30-point drop in the S&P
500 futures. If the S&P was at 1160 at
expiration (which is an approximately
30-point drop from the point this trade
was established), the maximum profit
increases to $900 from the original ver-
tical spreads $287.50.
The increased profit results from the
January 1070 put capitalizing on the
additional volatility and gaining from
downside price movement. Because it
expires in January rather than Dec-
ember, this option has additional time
value at the expiration of the
December short put. If the December
1155 short put option expires worth-
continued on p. 18
 TRADING STRATEGIES

FIGURE 4 — THREE-LEGGED SPREAD WITH VOLATILITY INCREASE

The expected profit for the revised spread in the event of a three-percent volatility increase is
$540.
less, you can pocket the
gain on the long January
put.
Profit/loss at If you recall, this
December
spread was established
expiration
for .65 or $162.50. At the
expiration of the
December 1155 put (with
the December futures set-
tling at 1160), the spread
will widen to $1,062.50 ––
a $900 profit (before com-
missions and fees).
Although we are assum-
ing the January futures
contract trades at the
same premium as
December futures (there
Source: OptionVue5 Option Analysis Software (www.optionvue.com) is typically a stable ratio
in equity index futures
during short-term time
frames, such as the one described
MANAGED MONEY here), the expected profit with a rise
in volatility now increases to $626, up
Top 10 option strategy traders ranked by August 2009 return. from the $380 in Figure 1, and up
from the $287.50 in the vertical
(Managing at least $1 million as of Aug. 31, 2009.)
spread.
August 2009 YTD $ under
Rank Trading advisor return return mgmt. Disadvantages, risks, and
another leg
1. CKP Finance Associates (Masters) 15.96% 174.59% 2.0 Margin requirements are higher
2. NEOS Advisors (Special Opportunities) 7.88% 8.36% 47.4 (about twice the level of initial margin
requirements) for the diagonal put
3. Washington (Singleton Fund) 7.58% 35.95% 55.7
spread, so the higher expected profit
4. ACE Investment Strat (ASIPC INST) 5.39% 26.08% 1.3 essentially requires equal additional
5. LJM Partners (Aggr. Premium Writing) 4.75% 21.20% 26.0 risk to obtain.
However, if you keep the original
6. ACE Investment Strategists (ASIPC) 4.53% 27.26% 3.6 December 1135 long put bought at .80
7. Kingsview Mgmt (Retail) 4.25% 16.00% 3.0 and add the long January 1070 put
(creating a three-legged vertical-diag-
8. ACE Investment Strategists (DPC) 4.19% 64.42% 16.3
onal combination trade), the margin
9. Oak Investment Group (Ag Options) 4.18% 47.35% 4.4 requirement drops to $3,800, about
10. Nantucket Hedge Fund - CTA 3.40% -4.97% 4.4 $500 below the vertical put spread’s
original margin requirement. Figure 3
reveals that the expected probability
Source: Barclay Hedge (www.barclayhedge.com) Based on estimates of the composite of all
of profit remains the same at 98 per-
accounts or the fully funded subset method. Does not reflect the performance of any single account.
PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE.
cent, with an expected profit of $258
with no volatility change, and $540 in
the event of a three-percent volatility

18 October 2009 • FUTURES & OPTIONS TRADER


increase (Figure 4).
Thus, by leaving in place the origi-
nal December 1135 long put and going
diagonal with the January 1070 put,
the expected $540 profit (with a mod-
est correction to 1160) can be obtained
on margin that does not exceed $4,500
for this trade. This represents a 12-per-
cent profit-to-margin ratio. If the
unchanged-volatility expected profit is
used, the rate of return on margin is
5.7 percent.
For the original vertical credit
spread, the return on margin of $4,700
(which is the maximum requirement
down to 1160 on the S&P 500) is 6.1
percent. While the unchanged-volatil-
ity profit on margin is slightly lower
for the diagonal spread, there is an
additional profit potential of 6 percent
from a rise in volatility, which more
than compensates for the commission
costs of the purchase of the additional
long December 1135 put.
Three good tools for targeting customers . . .
Bob Dorman
Ad sales East Coast and Midwest
bdorman@activetradermag.com
(312) 775-5421
FUTURES & OPTIONS TRADER • October 2009
Getting more out of
volatility and time decay
The traditional vertical credit spread
has limited risk but limited profit
potential as well. However, by con-
structing a diagonal put spread, addi-
tional profit can be extracted from
time decay and volatility increases.
(But not without an equal increase in
risk.)
But, if you leave the original vertical
put spread structure in place and add
a January long put to create another
version of a diagonal spread (a three-
legged vertical-diagonal combination
strategy), there is a potential jump
from 6.1-percent to 12-percent in prof-
it on margin. This result stems from a
hypothetical increase in volatility aris-
ing from a modest correction in the
S&P 500.
For information on the author see p. 6.
— CONTACT —
Allison Chee
Ad sales West Coast and Southwest
achee@activetradermag.com
(415) 272-0999
Related reading:
“Option spreads:
The reinsurance approach”
Active Trader, July 2004.
An analysis of option credit spreads
from the perspective
of playing the odds the way
insurers and casinos do.
“Timing events with the
calendar spread”
Active Trader, October 2003.
The calendar spread offers a way
to capitalize on aspects of time,
market direction and volatility.
“Controlling risk with spreads”
Active Trader, March 2003.
Trading the bull call-option spread.
“Extra credit (spreads)”
Active Trader, February 2002.
Another look at trading credit
spreads.
“Spreading
your charting options”
Active Trader, July 2000.
How to know what strategies are
appropriate for different market
conditions.
Mark Seger
Account Executive
seger@activetradermag.com
(312) 377-9435
19