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Trading Diagonals

Best Practices

A Diagonal Spread is the combination of a Vertical Spread and a Calendar Spread. When the long part of the diagonal is well in-the-money and the short end is out the position is also known as a Poor Man’s Covered Call (or Put) as it mimics that position. What is important to know about diagonals?

Tom said, “Think of a Diagonal spread as a low Volatility trade where you're combining a directional debit spread with a Calendar spread. Its like two trades in one with a fewer amount of contracts. Recently Volatility has popped up but when it contracts this is something to have in your back pocket.”

A graphic guideline of how to use the width of the strikes of a Diagonal spread to estimate a profit potential was displayed. This is only a guideline and because there are two different expirations there is no absolute maximum profit. The maximum loss is, of course, the debit paid. Be careful with that debit. Depending upon how it is set up it may exceed the width of the strikes. An example of a negative profit expectation (despite positive Deltas) if the stock explodes to the upside and the options trade at intrinsic value was displayed.

Tom added, “With a Calendar spread, you can get burnt on big moves (up or down). A Diagonal is a way to sell premium, but if you get a giant move, you're probably not going to make any money.”

A target for taking winners is 50% of the width of the strikes. When using Diagonals as a Poor Man’s Covered Call or Put, it’s common to pay 75% of the width. Remember the connection between risk and success. The more risk you take the larger is your Probability Of Profit (POP).

For more information on Diagonal Spreads see:

Watch this segment of Best Practices with Tom Sosnoff and Tony Battista for a better understanding of diagonal spreads and some guidelines on their use.

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