Back to Page 1

Diagonal Spread Strategy - Page 2

Analyzing risk/reward

Understanding the risk of a diagonal spread is the easiest part of the analysis process since my risk is simply the initial debit paid to enter the spread. Each roll will reduce this risk further.

Calculating the potential reward is more difficult though. To be effective in analyzing the reward, I need to consider several outcomes.

  1. What if the underlying moves right through my short strike and beyond?
  2. What if the underlying moves up but not all the way to the short strike by expiration?
  3. What if I successfully rolled and the stock continues to move up?

It definitely more complicated but not impossible to assess. To begin with, let's consider the scenario of moving up through my short strike significantly

Diagonal spread simulation (courtesy of the OIC)

I can enter this trade for about $3.54 or $354 per contract. If 5 days prior to expiration QQQQ is at $45, it will likely be impractical to roll. In this case, my profit is $163 or 46% return.

Now let's consider what happens if QQQQ moves right up to my short strike by about a week before expiration. It's difficult to calculate the potential roll value, however I can use the same OIC position simulator to calculate what a roll/close would be worth at about 5 days until expiraiton.

Diagonal spread OIC simulation

What I've done is enter in an August/September $40 call calendar spread and then move time forward to 5 days before expiration. Potentially, I could roll the short strike from August to September for about $.90. This means I could reduce my initial debit by that amount, thereby reducing my risk in the trade from $3.54 to $2.64.

The final scenario to look at is what if after my first roll, the stock moves up and through my short strike. What will the final profit potentially be? In the first scenario, the profit on the first month would be about $1.63. The simplest way to calculate this last scenario is to simply add the roll value to the initial profit, making the final result $2.53 or an ROI of 71%. This would be about the best outcome possible for the trade.

To avoid too much confusion, I'll save some other potential scenarios until the trade exit section.

Placing the order

It's best if this order is placed as one trade, however it is possible to buy the long strike on the bounce/breakout and sell the short strike after a move in the desired direction. However, this runs the risk of the opposite happening.

I will be talking about possible exit strategies later to limit loss, but I always size my position based on my potential maximum loss. If for example, I am willing to risk 2% of $20,000 and my initial cost to enter the diagonal spread is $3.54 (or $354 per contract), I can only take a 1 contract position. I should mention that it is rare to loose the entire cost of the spread, but it only needs to happen a few times for me to be on the sidelines wishing I had money to trade with.

Many brokers require approval for level 3 trading authority, which allows right to trade spreads. Before you begin trading spreads, you may want to check with your broker to make sure you are approved.

Most options brokers support placing both legs of the trade simultaneously. I recommend doing so if it is supported.

Most options brokers designate opening orders differently than closing orders. In this case to enter the trade, I might place an order to 'Buy to open' the October 38 call and 'Sell to open' the August 40 call for a net debit of $3.54. With this order, I either get filled on both legs or I don't get filled at all.

Trade exit

With the diagonal spread, I will need to place some kind of closing order to realize any profit in the trade. As I mentioned earlier, one exit I might choose if the stock moves well past my $40 strike price is to simply sell my long strike while simultaneously buying back my short strike. With a spread of $5 between the short and long strikes, I should be able to close the spread for a credit of at least $5 if I do so fairly close to the expiration date of the short strike.

Before I talk about some basic exit rules I might apply to this kind of trade, I want to talk about a couple of additional scenarios. In the analysis section I talked about a couple of roll and exit scenarios. But could also simply buy back the short strike at some point in the trade and wait for an opportunity to sell the next month. In other words, I don't have to simultaneously close the front month and place a trade for the next month. I might wait for a move up (or down if I'm trading a put diagonal) before selling the next month's option. In this case, I might not only sell the next month, but sell a different strike price.

If the stock makes a nice move in my desired direction, then I could pick up an additional $1 or $2 in the spread, thus increasing my upside potential. Knowing these possible choices allows me to establish some basic exit strategies that I can establish when I place a trade.

With that said, here are some rules I will generally always follow when placing a diagonal spread trade.

  • Exit or roll to the next month 5-7 days prior to expiration of the short strike.
  • Buy back the short strike when it doesn't make sense to hold it. For example, if the cost to close is less than $.10.
  • Roll the position any time I can get a credit greater than 20% of the initial debit.
  • Close the entire position if the value that I can close it for is less than 50% of my initial debit. That means I'm probably wrong and should just exit and look for a new trade.

Summary

The diagonal spread trade is one of the more complex strategies for options spreads. This is mostly due to number of choices available. I'd recommend mastering calendar spreads and vertical spreads before attempting to trade a diagonal spread.

Finally, I want to point out that as I've discussed the various steps to trading the diagonal spread, I've followed a fairly structured approach (selecting the right stock, timing the entry, selecting the right options, entry, exit, etc). These are based on a set of trading rules I follow, which are part of an overall option trading system I follow. This is a critical aspect of successful options trading. I've found I can't be successful trading any strategy just by knowing the mechanics. Having a system that defines what I do every time I trade is what helps me be consistent in my profits.

Outlook: Medium term bullish  (call diagonal) - Medium term bearish  (put diagonal)
Max profit: Difficult to calculate
Max Loss: Initial debit of the spread
Net Position: Neutral - not really long or short
Time decay effect:  Works in your favor
Volatility effect: Benefits from an increase in volatility

Return to Diagonal Spread - Page 1



[?] Subscribe To This Site

XML RSS
follow us in feedly
Add to My Yahoo!






























Newsletter Subscription

Name


Email

I keep this private



Subscribe now to receive your free promotional package.