Witch Time should be used much more sparingly than in an average matchup. Since Diddy's main close-range attack is grab, you won't be able to get too many Witch Times. It can still be used, but since Diddy won't be going for too many aggressive options, you will probably miss more than you hit. The best option to hit a Witch Time against is his fair. Diddy players love shorthop fair, so if they're getting predictable, you can go for the counter. As for punishing when you do get it, it's pretty much just the same as with everyone else. Rack up damage, start a combo, or charge an up smash, depending on percent.
Bayonetta