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Diagonal spreads and diagonal ratio spreads possess the same overall characteristics, save one. Both are composed of:
- Near-term short calls (or puts) and
- Longer- term long calls (or puts) with different strike prices and different expiries.
But where the number of short and long options are the same in a diagonal spread, they’re different in a diagonal ratio spread.
The reason for the difference is simple. The rationale behind the diagonal ratio spread is to pay for the longer-term options with the shorter. And that often requires a ratio of 2-to-1 or 3-to-2 (or more) to accomplish.
For example, the first leg of a put diagonal ratio spread might require you to sell four at-the-money puts with an expiry of less than 30 days. The next leg would be to buy two or three out-of-the-money puts with an expiry in a later month.
When Is the Strategy Used?
The put diagonal ratio spread strategy is employed when traders expect the underlying to experience little volatility before the near-term expiration, and a more powerful move into the money by the longer-term.
Below, we highlight six months’ worth of trade in Target Corp. (NYSE: TGT), the better to understand the setup, risks and potential payoff of the put diagonal ratio spread.
It’s now May, and after a steep climb for Target shares, you estimate that a cooling off period is in order. Your research also suggests that the price rise was overdone, but you don’t expect the shares to retrace until at least the next earnings report in July.
To take advantage of the drop, you contemplate a straight put purchase, but that appears a tad risky. What if the move lower takes longer to transpire? You don’t want to lose the whole bet just because your timing is off. Is there a way to hedge against such an outcome?
Indeed, a little more research reveals the answer. By writing near-term puts against the longer-dated purchase, you can even effect a net credit for the trade.
The Slide Abides
With Target trading at $70, you jump into action (red circle). You sell three June 70 puts for $2 each and buy two September 67 puts for $2.75 each (small black squares). Your total credit on the play is $0.50.
And your instincts are dead on. Target drifts in the $69-$70 range until well into July, long after your short puts expire out-of-the-money worthless on the third Friday of June (blue circle).
So far so good. You’re now sitting on two long puts (and $50 premium) with three months to go before expiry.
And the stock begins to hop. First higher, then steeply lower, plumbing to $63 before finally settling at $63.85 by expiry (black circle).
Your profit is $680 ([$67 – $63.85 + $0.50] x 100).
Best and Worst Cases
Diagonal ratio spreads have unlimited upsides, so long as the initial short position expires out of (or even close to) the money. On the downside, calculating exact break-even points or maximum losses are all but impossible, given the different expiries.
The worst-case scenario would entail the underlying surging strongly against the short options, creating a massive loss position, then returning to close out of the money by the latter expiry.
Best always to close the trade immediately if it moves against you at the outset.
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