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How To Trade Options: Protect The Downside In Small Caps With A Diagonal Put Spread

Want to know how to trade options with success? Always consider the general market first. The iShares Russell 2000 ETF (IWM) has been under pressure lately. As noted in IBD’s market columns such as The Big Picture, IWM is the only major index below its 50-day moving average.




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That’s typically a bearish development. So, it might be worth looking at adding some downside protection. (IWM)

One way to do so? Put on a diagonal put spread.

In a diagonal put spread, we buy a long-term in-the-money put option and then sell an out-of-the-money put against it.

How To Trade Options: Building The Diagonal Put Spread

For IWM, we could look at buying a Sept. 17-expiring put option with a 235 strike that recently traded around $23.70 and selling a May 21 put at 205 for around $2.85.

The total cost of the trade is the net premium paid, estimated to be around $20.85, or $2,085 for a standard contract of 100 shares.

The strategy earns the most profit if IWM closes right at 205 at May expiry, where the profits are estimated to be around $1,000 per contract.

If IWM drops even further, the trade will still make around $800. This is the lowest profit if the stock drops and it doesn’t matter how far it drops.

The maximum loss is limited to the premium paid of $2,085.

Where To Set A Stop

The break-even price for the trade is estimated at around 220. But that can change depending on the changes in implied volatility.

The net delta on the trade is -40 so the exposure is roughly equivalent to being short 40 shares of IWM, although this will change as the stock moves and the trade progresses.

In terms of risk management, I would set a stop loss of 20%. If the trade is down roughly $420, I would close it out.

Adding some bearish trades to your option portfolio can help offset the risk of other bullish trades and neutralize your overall market exposure.

Options are risky. Investors can lose 100% of their investment.

This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions. Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ

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