One of the wide variety of strategies options traders can employ with limited risk is the Put Diagonal Calendar Spread. It can be used when the market is likely to track sideways for a while. The trader can either make a profit from the option trade or end up with shares in the underlying and still have insurance on them.
The mechanics of the trade are relatively simple; the trader sells an ATM or slightly ITM Put option for a front month, say January, and then buys a February Put option one strike lower. The trade can usually be done for close to even money and the maximum risk is limited to the width of the spread should the shares fall and the trader is assigned shares from the short Put. The long Put will as insurance until the February expiration.
At the January expiry the trader can let the front option expire if it’s out of the money or buy it back if it’s in the money and then sell the long February Put and make a slight profit or small loss on the trade. Or, if the Put option is in the money, they can have the stock “put” to them and allow the price of the short put offset the cost of the shares.
For example, if a stock has been selling in a channel between $50 and $55 for several months the trader can sell a January $51 Put for $2.80 and buy a February $50 Put for $2.95 for a debit of $1.50. If the January $51 expires out of the money (and worthless) then the trader only has to sell the February $50 Put for more than 15 cents to make a profit.
However, if the stock dropped a certain amount and the trader was assigned the shares on the short January $51 Put, he would still have the long February $50 Put as insurance and would have a lot more options regarding what he wanted to do with the position. One scenario would be to sell a longer-term (perhaps March or April) OTM covered call to mitigate the current $1.50 risk on the trade—and could actually end up making a very good profit on the entire transaction over time.
Options give traders an increased ability to limit risk and to quickly get to profitability and/or to adjust a trades as market conditions change.
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