Diagonal Spread With Puts
Again, let us discuss 'Diagonal Spread' now using Put options.
This again is a two-step strategy, which is a cross between a long calendar spread with puts and a short put spread. Here again we can play with different maturities.
This strategy involves selling an OTM put (say for strike 17500 for January expiry when Nifty is trading at 17600) and buying a further OTM put (say strike 17300 for February expiry). When the January put expires, we sell another put of strike 17500 (but now for February expiry).
Here, we expect neutral activity in the month of January, then neutral to bullish activity during the month of February.
For this strategy, before January expiration, time decay is our friend, since the shorter-term put will lose time value faster than the longer-term put. After closing the January put of 17500 and selling another put with the same strike but with February expiry, time decay is somewhat neutral. That’s because we’ll see erosion in the value of both the option we have sold (good) and the option we bought (bad).
After the strategy is established, although we want neutral movement on Nifty, we’re better off if IV increases close to January expiration. That way, we will receive a higher premium for selling another put at 17500.
After January expiration, we have legged into a short put spread.
If our forecast was correct and Nifty is approaching or above 17500, we want IV to decrease. That’s because it will decrease the value of both the options. Again here we want them to expire worthless.
If our forecast was incorrect and Nifty is approaching or below 17300, we want IV to increase. Firstly because it will increase the value of the near-the-money option we bought faster than the in-the-money option we sold, thereby decreasing the overall value of the spread. Secondly because it shows a higher probability of a price swing (hopefully be to the upside).