Market pullbacks often catch investors off-guard, leading to panic selling that crushes their portfolio. September, historically the worst-performing month for the stock market, is a time when investors often see significant losses. As stocks drop rapidly, traders are unable to control their risk and preserve their capital for fear of further losses. Volatility embarks upon the market with confusion, leaving many unsure of how to adjust trading strategies in response to bearish conditions.
Options trading has been one of the most appropriate avenues through which one could earn a profit both when the market is bullish and bearish. Unlike buy-and-hold, conventional strategies, options trading is flexible enough for a trader to gain in a falling market. Advanced options strategies, including the put diagonal spread, are those that are particularly tailored with some of the bearish conditions it has been going through and with seasonal declines like the historical market swoon in September.
What is The Put Diagonal Spread Strategy
One of the best ways to profit with the market feeling bearish is the Put Diagonal Spread. This options strategy takes advantage of falling stock prices in a market downtrend and protects at a fixed price while all those around may be in a state of panic.
Employing appropriate techniques in purchasing and selling puts through various expiration dates allows traders to take advantage of this strategy in managing the volatility of bearish markets while simultaneously positioning for profitable situations during an eventual market rebound, such as the widely recognized Santa Claus rally in December. The put diagonal spread will be discussed in further detail in this paper, including how it can be employed to navigate bearish markets.
How To Understand the Seasonal Nature of Markets
Market seasonality may perhaps be one of the most important factors in trading options. Months like September are the times when at least some major pullbacks of the stock market have taken place. In fact, the month of September is considered to be perhaps the worst month for the stock market. According to confirmations by Dow Jones Market Data, most of the September months have seen a decline wherein traders become risk-averse, and stocks start to sell off.
The year-end market does tend to rally, sometimes what is referred to as the “Santa Claus rally,” with December being an extremely bullish month. In knowing these patterns, the informed trader of options can devise strategies that capitalize on the lower trend in September and follow up with the upward trend towards the end of the year.
The Put Diagonal Spread
The put diagonal spread belongs to a higher level of options strategies. It involves the buying and selling of put options with different strike prices and expiration dates. In particular, it fits very well in bearish markets because a trader can take advantage of the short-term market decline and eventual rebound. Here’s how it works:
- Strategy to Buy a PUT Option: The trader buys a put option of near-month expiry, usually around the end of September, and normally much lower than the current market price.
- Selling the Put Option: Simultaneously sell a longer expiration put option, such as at the end of December. This can be at a strike price that is slightly below the bought put.
This is combined buying and selling of puts at different expiration dates to develop a diagonal spread uniquely designed to take advantage of market declines and eventual rebounds.
Example: September 2021
Let’s consider the case in September 2021. The market had been super bullish going into September, and the S&P 500 (tracked by the SPY ETF) was making new all-time highs. With SPY closing on September 1st at 451.88, a trader could buy a 450 strike price put option, expiring at the end of September, for $558. At the same time, the trader would sell a 440 strike put option expiring at the end of December, collecting $1,317.
This would have created an initial positive cash flow of $759. Since the market followed its history in September and started to sell off, the value of the purchased put increased greatly along with the profit. At the end of September, SPY had fallen to 429.14; the 450 strike put option was valued at 2139, hence giving tremendous returns to the trader.
Why the Put Diagonal Spread Works
Following are some reasons why the put diagonal spread is such an effective strategy in bear markets:
- Profit from Declines: The put option purchased for the near-term expiration-September rises in value when the market declines, thus allowing traders to lock in profits during the bearish phase of the market.
- Collect Cash Flow: By selling the longer-dated December put option at a significantly lower strike, the trader is getting an upfront premium that results in positive cash inflows at the time of trading.
- Capitalize on Market Rebounds: The market is more often than not ending the year higher, and therefore the option sold (with a December expiration) tends to expire worthless, thereby enabling the trader to retain the premium received at the time of sale.
Managing Risk with the Put Diagonal Spread
One of the major concerns while using the Put Diagonal Spread is the issue of risk management. This is a selling strategy for the put option; therefore, one might have an obligation to purchase shares if the market falls below the strike price of the sold put.
Referring to the previous example, if by December the market had fallen below 440, the trader would have been obligated to purchase 100 shares of SPY at 440, which can bring gigantic losses if the market kept falling.
However, there are a number of ways this risk can be mitigated:
- Monitor the Market: Traders can keep a lookout on the position in the market and modify it accordingly. Continuing with the example above, if the market continues to decline, the trader may want to close the trade early or roll the position to a lower strike.
- Capital Allocation: Traders must make provisions for the possible obligation of the purchase of shares when an assignment takes place on the sold put. That is, there needs to be sufficient cash in the trading account with which to purchase shares at the strike price of the sold put.
Example: September 2022
Conversely, September 2022 saw the bears take over as SPY dropped below 400 at the beginning of September. For instance, one could buy a 395-strike September-expiring put option and simultaneously sell a 385-strike December-expiring put option; such a trade would generate positive cash flow in the amount of $640.
By the end of September, SPY declined further, closing at 357.18, and the underlying purchased put option greatly increased in value, generating very large profit. By year’s end, however, SPY had rebounded somewhat, closing just below the 385 strike price, which meant the sold put option had some value, and the trader would have to buy it back to close the position. The trader still realized a hefty profit, nonetheless, because of the gains from the purchased put option earlier in the trade.
Conclusion
In the end, one of the best options strategies to consider in bearish markets is the put diagonal spread. It allows traders to profit from short-term market declines while still being able to maintain flexibility to capitalize on future market rallies. Market seasonality in combination with advanced options strategies, such as the put diagonal spread, provides traders with the ideal way to position themselves for a couple of violent market moves.
Be it braving the traditionally bearish month of September or positioning for a possible Santa Claus rally later, the put diagonal spread is ready as an exceptionally strong tool in keeping gains high and risk low—a time-tested approach by those traders seeking to profit from market declines.
