XLF Diagonal PUT Example

Let us analyze an example using XLF Puts. This example here teaches you about a diagonal Put spread.

1) Buy Jan 2012 Put , Strike Price 10.
Cost = 0.97 as of close today.

2) The above Put is purchased as a cushion + to provide the lower side of the spread.

3) Now, let us say if Dec 2010 Put is sold , Strike price 13.
Premium collected = .76

4) Margin held will be the difference in strike prices ; which will be $3

5) What is the ROI? Many ways to look at it. Let us analyze the traditional way.
Amount of money sank = $ 3 + .97 = 3.97
Premium collected = .76
Return = .76/3.97 = Approximately 19% on investment

6) In Dec, if XLF stays above 13, the premium collected stays with the investor.
Margin money of 3 bucks is also released.
Same steps can be repeated to sell puts in future months.
Upfront, after .76 is collected, the remaining amount to recover is 0.21
There is still 1+ year left to play the game.

7) What happens if by Dec close, XLF goes below 13 ?
Ideal scenario will be to roll down & roll out.
This implies that the Dec put can be bought back at a loss.
However, the amount paid to buy back, one can look into selling a lower or
equal strike price Put for future month, such as March. So the goal should be
to keep the same cash flow.

Rather than simply losing money, one should roll it so as to minimize the impact on cash flow or even make it positive. After all, what you sell can be bought back & a new position can be opened + you buy time.

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