A bearish diagonal spread on shares in George Weston Ltd.

As the following graph shows, prices for shares of George Weston Ltd. (WN) have broken below their trough of last September 2017 following a timid attempt at a rebound that lasted four months. Since peaking in January, 2018, WN has followed the general market trend by dropping swiftly, but the rally, which has been anemic, has hit a resistance level at around $105. Since the stock’s stochastic oscillator is under 30, the next significant move may be downward.

Daily graph as at February 15, 2018 ($103.81)

Assuming that the price of WN will stay below $105 for a while, we can implement a strategy that will allow us to profit from the time decay of the option resulting from this expected drop and relatively stable stock price. We will set up a bearish diagonal spread with put options by purchasing a put option, in-the-money, with an expiration that is later than a second put option, at-the-money or almost at-the-money, that we will write.

Position

• Purchase of 10 put options WN 180420 P 110 at $7.40
  • Debit of $7,400
• Sale of 10 put options WN 180316 P 105 at $2.95
  • Credit of $2,950
• Total debit of $4,450

Profit and loss diagram for the bearish diagonal spread using put options on WN expiring on March 16, 2018

Purchasing ten put options WN 180420 P 110 at $7.40 requires a disbursement of $7,400. This amount is partly offset by the $2,950 we receive from writing ten put options WN 180316 P 105 at $2.95. The total disbursement is therefore $4,450, which represents the maximum loss if the stock price surges. As you can see in the above graph, this strategy will yield a profit on expiration of the options on March 16, 2018 if WN is trading at a price below the $106.97 breakeven price.* Furthermore, the maximum profit* of $1,375 will be realized if WN closes exactly on the $105 strike. If the price of WN drops significantly, the position will tend to generate a profit of approximately $500.* This strategy would allow us to profit from the time decay of the put options written, expiring on March 16, 2018, if the price of WN drops or remains relatively unchanged.

Intervention

Even though we expect the stock to trend downward somewhat over the next few weeks, the situation may still play out quite differently. If WN climbs in price, we have a bit of flexibility up to the $106.97 breakeven price. But if WN starts to trade significantly above this price, then we need to take defensive measures to limit our potential losses. At that point, the simplest solution would be to admit that we were wrong and liquidate the position.

In the event that WN closes at close to or much lower than $105 upon expiration on March 16, 2018, another possibility opens up. If we believe that the stock has the same prospects then as it does today, we could write more put options, expiring on April 20, 2018 this time, and once again try to profit from the time decay of options that are at-the-money (or almost at-the-money). Another valid scenario would be to simply take our profits at that time if we have a different outlook for the stock.

It is essential to point out that this strategy needs to be actively managed, so it is only suited for investors with ample trading options experience.

Good luck with your trading, and have a good week!

*The breakeven price and the forecast profits or losses are only estimates based on the assumed value, on March 16, 2018, of the put options with an April 20, 2018 expiration.

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.