Description:
This is a diagonal spread consisting of a long position in a deep ITM put option with a strike price K1 and TTM T′, and a short position in an OTM put option with a strike price K2 and shorter TTM T < T′. This is a net debit trade. The trader’s outlook is bearish.
At t = T let V be the value of the long put option (expiring at t = T′) assuming ST = K.
If at the expiration of the short put option the stock price K2 ≤ ST ≤ Sstop−loss, where Sstop−loss is the stop-loss price above which the trader would unwind the entire position, then the trader can write another OTM put option with TTM T1 < T′. While maintaining the long position in the put option with TTM T′, the trader can generate income by periodically selling OTM put options with shorter maturities. In this regard, this strategy is similar to the calendar put spread. The main difference is that, in the diagonal put spread the deep ITM put option (unlike the close to ATM put option in the calendar put spread) more closely mimics the
underlying stock, so the position is more protected against a sharp drop in the stock price.
