How to Trade Diagonal Option Spreads

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The diagonal option spread offers a great compromise between the vertical spread and the horizontal spread. It incorporates the best features of each while diagonal option trade some of the drawbacks of each. For the discussion here, we will consider only debit spreads.

Then you sell a Call Put with a higher lower strike price. Both Calls Puts will have the same expiration date. The Vertical Spread achieves its maximum return at expiration when the price of the underlying diagonal option trade has moved beyond the strike price of the short option. Shortcomings of the Vertical Spread: Must wait until the expiration of both options to achieve the diagonal option trade profit.

Profit is limited to the difference between the two strike prices less the net cost of the spread. The expiration date of the long Call Put is typically weeks in the future. Then you sell a Call Put with the same strike price and a closer expiration date. The Horizontal Spread diagonal option trade its maximum return if the stock price is very near the common strike price when the short Call Put expires.

Shortcomings of the Horizontal Spread: The stock price must be very near the common strike price diagonal option trade expiration in order to have a reasonable profit. If the stock price is even modestly removed up or down from the strike price, the spread is unlikely to produce a profit.

Must be wary of any event earnings report, etc that might cause a large move in the stock price prior to the near term expiration date.

You buy a Call Put that has a delta of magnitude. Then you sell a Call Put with a higher lower strike price that has a closer expiration date.

The Diagonal Spread has the advantage of directional movement offered by the Vertical Spread, while also providing the relatively quick expiration diagonal option trade the short option offered by the Horizontal Spread.

If weekly options are available, there is substantial flexibility in selecting the time frame over which the trade can be maintained.

At Connors Research, we are using it as an overlay to many of our best strategies to make them even better -- now you can, too. Chief Options Strategist Dr. Edward Olmstead, is the author of Options for the Beginner and Beyond: Unlock the Opportunities and Minimize the Risksthe 1 best seller among all options investing books on Amazon.

From — he served as the original editor of The Options Professora popular newsletter on options trading and has consulted on short-term trading strategies with member companies of the Chicago Mercantile Exchange.

He has taught courses that cover diagonal option trade the theory for options pricing and practical strategies for trading options. The Connors Group, Inc.

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This graph assumes the strategy was established for a net debit. Also, notice the profit and loss lines are not straight. Straight lines and hard angles usually indicate that all options in the strategy have the same expiration date. You can think of this as a two-step strategy. It starts out as a time decay play. Then once you sell a second call with strike A after front-month expiration , you have legged into a short call spread. Ideally, you will be able to establish this strategy for a net credit or for a small net debit.

Then, the sale of the second call will be all gravy. But please note, it is possible to use different time intervals. Ideally, you want some initial volatility with some predictability. Some volatility is good, because the plan is to sell two options, and you want to get as much as possible for them.

On the other hand, we want the stock price to remain relatively stable. To run this strategy, you need to know how to manage the risk of early assignment on your short options.

It is possible to approximate break-even points, but there are too many variables to give an exact formula. For step one, you want the stock price to stay at or around strike A until expiration of the front-month option.

Potential profit is limited to the net credit received for selling both calls with strike A, minus the premium paid for the call with strike B. If established for a net credit, risk is limited to the difference between strike A and strike B, minus the net credit received.

If established for a net debit, risk is limited to the difference between strike A and strike B, plus the net debit paid. Margin requirement is the difference between the strike prices if the position is closed at expiration of the front-month option.

If established for a net credit, the proceeds may be applied to the initial margin requirement. Keep in mind this requirement is on a per-unit basis. For this strategy, before front-month expiration, time decay is your friend, since the shorter-term call will lose time value faster than the longer-term call. After closing the front-month call with strike A and selling another call with strike A that has the same expiration as the back-month call with strike B, time decay is somewhat neutral.

That way, you will receive a higher premium for selling another call at strike A. After front-month expiration, you have legged into a short call spread. So the effect of implied volatility depends on where the stock is relative to your strike prices. If your forecast was correct and the stock price is approaching or below strike A, you want implied volatility to decrease. If your forecast was incorrect and the stock price is approaching or above strike B, you want implied volatility to increase for two reasons.

First, it will increase the value of the near-the-money option you bought faster than the in-the-money option you sold, thereby decreasing the overall value of the spread.

Second, it reflects an increased probability of a price swing which will hopefully be to the downside. Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options.

Options investors may lose the entire amount of their investment in a relatively short period of time. Multiple leg options strategies involve additional risks , and may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies. Implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or the probability of reaching a specific price point.

The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract.

There is no guarantee that the forecasts of implied volatility or the Greeks will be correct. Ally Invest provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. System response and access times may vary due to market conditions, system performance, and other factors. Content, research, tools, and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy.

The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, are not guaranteed for accuracy or completeness, do not reflect actual investment results and are not guarantees of future results. All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns.

The Options Playbook Featuring 40 options strategies for bulls, bears, rookies, all-stars and everyone in between. The Strategy You can think of this as a two-step strategy. Options Guy's Tips Ideally, you want some initial volatility with some predictability.

The Setup Sell an out-of-the-money call, strike price A approx. Break-even at Expiration It is possible to approximate break-even points, but there are too many variables to give an exact formula. The Sweet Spot For step one, you want the stock price to stay at or around strike A until expiration of the front-month option.

Maximum Potential Profit Potential profit is limited to the net credit received for selling both calls with strike A, minus the premium paid for the call with strike B. Maximum Potential Loss If established for a net credit, risk is limited to the difference between strike A and strike B, minus the net credit received.

Ally Invest Margin Requirement Margin requirement is the difference between the strike prices if the position is closed at expiration of the front-month option. As Time Goes By For this strategy, before front-month expiration, time decay is your friend, since the shorter-term call will lose time value faster than the longer-term call.