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The diagonal bear put spread is the counterpart to the diagonal bull call spread and is written in expectation of a sideways move in the underlying stock over the near term, followed by a sharp spike lower.
The drop might be precipitated by a poor earnings report, a failure to receive regulatory approval or after a significant announcement from a competitor, to name just a few possibilities.
How to Trade It
The diagonal bear put spread is composed of the purchase of a longer-dated at-the-money or slightly in-the-money put option and the concurrent sale of a short-term, out-of-the-money put option.
It’s designed with the expectation that the near-term put will expire worthless, leaving the (now cheaper) long put open to capitalize on any abrupt drop in the underlying security.
A look at a chart of crude oil illustrates the idea nicely:
The above chart is of the United States Oil Fund (NYSEArca:USO), a proxy for Nymex crude oil.
The commodity has been in a bear market for roughly a year, and because you’re a shrewd investor, you see the bounce higher from the March bottom (left of chart) as just a temporary phenomenon. By mid-May (red circle), you decide to employ a diagonal bear put spread strategy in preparation for the next leg down.
Your choice is based on your understanding that oil is likely to remain in a bear market, but will only resume its slide after a brief drift sideways to lower. You set the trade accordingly.
You buy the at-the-money August 20 put for $6.10 and sell the June 18 put for $3.90 (both in blue). Your total debit on the spread is therefore $2.20 ($6.10 – $3.90) with less than 30 days to go before the expiry of the short option.
On the other hand, you’re also fully aware of the dangers of the trade. Should things go awry and oil begin to move higher – closing above the $20 level by the August expiry – both options will expire worthless and you’ll be out your initial $220 investment (net commissions).
That’s the worst-case scenario for the trade.
And how do things end up?
As it turns out, the June expiry rolls around with the stock still hugging the $20 level. Your $18 put expires worthless, bagging you the full premium, and you now await the action moving into the mid-summer heat.
Bingo! July opens with a steep gap lower and your August 20 put is fast gaining value. You have a hunch there’s more in store, so you let it ride through expiration.
And that’s where it ends.
USO closes on the third Friday of August at $13.40 (green circle), putting you $6.60 in-the-money ($20 – $13.40) and netting you a profit of $440 ($6.60 – $2.20 [your original outlay on the trade] x 100). As a reminder, one options contract equals 100 shares of stock.
That’s a 100% take ($440 on $220 expended), and that ain’t bad at all.
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