The Unlucky Investor's Guide to Options Trading guides readers through the world of options and teaches the crucial risk management techniques for sustainable investing.
A Diagonal Spread is constructed by purchasing a call/put far out in time, and selling a near term put/call on a further OTM strike to reduce cost basis. The trade has only two legs, but it gives the effect of a long vertical spread in terms of directionality, and a calendar spread in terms of its positive vega.
A Long Put Diagonal Spread is constructed by purchasing a put far out in time, and selling a near term put on a further OTM strike to reduce cost basis. The trade has only two legs, but it gives the effect of a long vertical spread in terms of directionality, and a calendar spread in terms of its positive vega. This results in a bearish position that can benefit from an increase in implied volatility. A Long Put Diagonal Spread is usually used to replicate a covered put position.
A Long Call Diagonal Spread is constructed by purchasing a call far out in time, and selling a near term call on a further OTM strike to reduce cost basis. This trade has only two legs, but it gives the effect of a long vertical spread in terms of directionality, and a calendar spread in terms of its positive vega. This results in a bullish position that can benefit from an increase in implied volatility. A Long Call Diagonal Spread is usually used to replicate a covered call position.
The trade will be entered for a debit. It’s important that the debit paid is no more than 75% of the width of the strikes.
XYZ Stock at $100
Purchase (Expiration 2) 110 put for $15
Sell (Expiration 1) 90 put for $5.00
Net debit = $10.00 on a 20-point-wide long put diagonal spread
XYZ Stock at $100
Purchase (Expiration 2) 90 call for $15
Sell (Expiration 1) 110 call for $5
Net debit = $10.00 on a 20-point-wide long call diagonal spread
HOW TO CALCULATE MAX PROFIT / BREAKEVEN(S)
The exact maximum profit potential cannot be calculated due to the differing expiration cycles used. However, the profit potential can be estimated with the following formulas.
LONG PUT DIAGONAL SPREAD
Width of Put Strikes - Net Debit Paid
LONG CALL DIAGONAL SPREAD
Width of Call Strikes - Net Debit Paid
The break-even cannot be calculated due to the differing expiration cycles used in the trade. As a rough estimate, the break-even area can be approximated with the following formulas.
LONG PUT DIAGONAL SPREAD
Long Put Strike Price - Net Debit Paid
LONG CALL DIAGONAL SPREAD
Long Call Strike Price + Net Debit Paid
The setup of a diagonal spread is very important. If we have a bad setup, we can actually set ourselves up to lose money if the trade moves in our direction too fast. To ensure we have a good setup, we check the extrinsic value of our longer dated ITM option. Once we figure that value, we ensure that the near term option we sell is equal to or greater than that amount. The deeper ITM our long option is, the easier this setup is to obtain. We also ensure that the total debit paid is not more than 75% of the width of the strikes.
We never route diagonal spreads in volatility instruments. Each expiration acts as its own underlying, so our max loss is not defined.
CLOSE / MANAGE
We generally look for 25-50% of max profit when closing diagonal spreads. Profit occurs when the long option moves further ITM and gains value, and/or if implied volatility increases.
We manage diagonal spreads when the stock price moves against our spread. In this case, we look to roll down the short option closer to the breakeven price, so that we can collect more premium and reduce our overall risk.
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