Diagonal Spreads Explained

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Diagonal Spreads Explained

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The Ultimate Guide to Double Diagonal Spreads

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Double diagonals are not your average options strategy. Let’s take a detailed look at this little known strategy and see if it’s worthy of adding to your option trading arsenal. We’ll look at:

  • Trade setup
  • Breakevens, max profit and max loss
  • How Implied volatility affects the trade
  • Managing the trade
  • Making adjustments
  • A comparison with iron condors
  • Using double diagonals in combination strategies

STRATEGY OVERVIEW

A double diagonal spread is made up of a diagonal call spread and a diagonal put spread. It is a fairly advanced option strategy and should only be attempted by experienced traders, and as always, you should paper trade this for 3-6 months before going live. The double diagonal is an income trade that benefits from the passage of time. Implied volatility is a crucial element of this strategy as you will learn below.

TRADE SETUP

You would enter a double diagonal spread when you anticipate minimal movement in the underlying over the course of the next month. As this is a long Vega trade, you may also be of the opinion that implied volatility will rise over the next month. This is the conundrum for double diagonal traders, they want volatility to remain flat or rise, yet they want the underlying to stay within a specified range. Typically, volatility spikes are associated with large movements in the underlying.

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Generally when entering a double diagonal trade, the underlying would be somewhere in the center of the two sold strikes. You can also trade this strategy with a bullish or bearish bias, although most option income traders would set it up as delta neutral or as close to it as possible. Here we see a fairly common set up for a trade using RUT:

Date: December 17 th , 2020

Stock Price: 835

Underlying Implied Volatility: 19%

Trade Setup:
Sell Jan 17, 2020 810 Put @ $10.65. IV = 20.03%
Buy Feb 14, 2020 800 Put @ $15.10. IV = 21.01%

Sell Jan 17, 2020 870 Call @ $3.35. IV = 16.23%
Buy Feb 14, 2020 880 Call @ $5.55. IV = 16.32%

Net Debit: $665

The below payoff diagram shows the two profit peaks at 810 and 870 with a small dip in the middle. The profit potential at the mid-point of the graph is around $250 assuming no change in implied volatility. The capital at risk is about $1,665, so the profit potential in the middle of the graph is roughly 15% with a higher potential towards the peaks.

OPTION GREEKS

Looking at the option Greeks for this trade, Delta is basically flat, Theta is 10 and Vega is 62. At the initiation of the trade, Vega has by far the most impact. The two diagrams below show this trade with both a +3% and -3% change in implied volatility after 1 day. You can see that a 3% move in volatility can have a significant effect on the trade.

Option Greeks at trade initiation

Day 1 with +3% move in Implied Volatility

day 1 with -3% move in Implied Volatility

MAXIMUM POTENTIAL PROFIT

Most standard option strategies have a clearly defined maximum profit. However, calculating the maximum profit, maximum loss and breakevens for advanced option strategies like the double diagonal is an inexact science. This is due to the fact that you are trading options with 2 separate expiry months.

Potential profit for this strategy is limited to the net credit received for the sale of the front month options, plus the net credit received when closing the back month options, less the original net debit paid for the back month options.

The ideal situation for this trade is that the underlying stays in between your short strikes. Some traders may look at an expiry risk graph for a double diagonal and assume that it would be better for the stock to end near the short strikes. It may be the case that you make a bit more when selling the back month options, however, having the underlying near your short strikes near expiry means there is an increased chance of the underlying blowing right past your short strike.

MAXIMUM POTENTIAL LOSS

If you are able to open the position for a net credit, the maximum loss is limited to the difference between the strike prices, less the premium received.

If you open the position for a net debit, the maximum loss is the difference between the strike prices, plus the premium paid.

BREAKEVENS AT EXPIRY

There are too many variables to calculate an exact breakeven at expiry. Most brokers, including Optionshouse, ThinkorSwim and Interactive Brokers have profit and loss calculators that let you take into account potential changes in implied volatility levels.

The best way to look at your expiry graph would be to assume no change in volatility over the course of the trade. Keep in mind that a decrease in implied volatility will bring your breakevens closer to your short strikes and an increase in implied volatility will move them further away from your short strike.

THE EFFECT OF IMPLIED VOLATILITY

Traders should have a solid understanding of implied volatility before attempting this strategy as it will have a significant impact on the trade. The ideal scenario is for the underlying to stay within the two sold strikes until near expiration when you want volatility to spike up, ideally with a move towards the sold strikes.

NET CREDIT OR DEBIT WHEN OPENING THE TRADE?

When initiating a trade, it is preferable to try and receive a net credit, but it is not always possible, nor is it essential to having a profitable outcome. The trade may be entered for a net debit and still make a profit if you can cover up the debit when you sell the back month options after the front month options. When choosing whether to open a trade, it is more important to look at the expiration profit graph rather than the initial debit or credit.

DAN SHERIDAN’S TIPS FOR ENTERING A DOUBLE DIAGONAL

Dan Sheridan is the guru when it comes to double diagonals, let’s take a look at the way he goes about entering a trade:

1. Sell the call option strike (minimum $0.50 for short option) in the front month, that is the first strike inside 1 standard deviation
2. Sell the put option strike (minimum $0.50 for short option) in the front month, that is the first strike inside 1 standard deviation
3. Buy a call one to two months out from the short call and up one strike (maximum 1.5 times price of the short call)
4. Buy a put one to two months out from the short call and down one strike (maximum 1.5 times price of the short call)
5. If the profit and loss graph sags in the middle, then bring the short and long options in 1 strike
6. If a negative skew of more than 2 exists (long month minus the short month), then don’t do the trade!
7. If a positive skew of 4 or more exists, then investigate
8. Know the earnings date and past gap potential

WHAT INSTRUMENTS TO TRADE

When trading double diagonals, it’s important to choose the right underlying stock, index or ETF. Here are a couple of guidelines to keep in mind:

  • Stocks that are greater than $30
  • Implied volatility (IV) is in lowest third of its two-year range
  • Nontrenders, sideways movers
  • Low volatilities (we want sideways movement, not wild swings)
  • Skews (volatilities near and far) in line, not more than four points apart
  • Nonearnings months — again, we don’t want movement due to news
  • Boring, sideways, predictable industries, no biotech startups or the like.

MANAGING THE TRADE

Managing a double diagonal trade need not be as hard as you might think. Here are a few simple rules to follow that will help you achieve success with this strategy.

  • Typically a double diagonal would be entered with between 30 and 60 days until expiration of the short options.
  • Profit target should be around 15-20%
  • Stop loss set at -25%
  • If within 10 days of putting on the trade, the underlying is approaching one of your short options, you should consider adjusting or taking the entire position off.
  • If after 10 days, your short strikes are hit, you should consider adjusting or taking the entire position off
  • Generally you do not want to hold a double diagonal into expiry week of the short options.
  • You can use back month options that are more than one month out from your short options. This will give you a greater long Vega exposure. To do this you would need to have a good understanding of how to roll option positions unless you plan on closing the entire trade when the front month nears expiration.
  • You may want to use index options rather than ETF’s or stocks to avoid the risk of early assignment
  • Avoid a saggy middle – no one likes a saggy middle, options traders included. To avoid a saggy middle on your profit graph, bring all your options in closer to the money

ADJUSTING DOUBLE DIAGONALS

Double diagonals can be tricky to adjust, particularly as you approach expiration. For tips on adjusting double diagonals, let’s again go to the master, Dan Sheridan. During a webinar conducted on February 7, 2008, Sheridan gave an example of a trade entered on OIH.

Trade Date: Dec 10 th , 2007.

Stock Price: $185

Underlying Volatility: 30%

Trade Setup:
Buy 1 April 200 OIH Call @ $8.70
Sell 1 Jan 195 OIH Call @ $3.30
Sell 1 Jan 175 OIH Put @ $3.60
Buy 1 Apr 170 OIH Put @ $7.90

Net Debit: $970

Capital at Risk / Max Loss: $1,470

OIH Double Diagonal – Opening Greeks

OIH Double Diagonal – Opening Risk Chart

By December 17 th , OIH had dropped from $ 185 to $177 which was close to the short strike of $175. This is how the trade looked at this point. As you can see, it was time to make an adjustment.

Risk Graph after 7 days and a drop of $8

Sheridan then goes on to present 3 different adjustment options:

1. Buy to close the Jan 175 puts and Sell to open Jan 170 puts (changes put diagonal into a calendar). With this adjustment, delta is reduced from 16 to 6 while Theta, Vega and Gamma all stay about the same. The adjustment cost $190.

Buy 1 Jan $175 OIH Put @ $6.30
Sell 1 Jan $170 OIH Put @ $4.40

Net debit: $190

Adjustment #1 – Change in Greeks

Adjustment #1 – New Risk Graph

2. Sell to open Jan 170 puts and Buy to open Apr 175 puts (changes the put diagonal into a double calendar). With this adjustment, delta is reduced from 16 down to 5, Theta is almost doubled from 7 to 12 and Vega is increased by 50% from 40 to 61. The adjustment cost $800 and increased capital at risk because the position now has a double calendar in place of a single put diagonal.

Sell 1 Jan $170 OIH Put @ $4.40
Buy 1 Apr $175 OIH Put @ $12.40

Net Debit: $800

Adjustment #2 – Change in Greeks

Adjustment #2 – New Risk Graph

You can see that this adjustment has a much higher profit potential, but the trade-off is more capital at risk and a higher Vega exposure.

3. Take off entire put diagonal and reposition down one strike for long and short puts. With this adjustment Delta is reduced from 16 to 11, Theta and Vega stay the same and Gamma is down to -1 from -2.

Buy to close 1 Jan $175 OIH Put @ $6.30
Sell to close 1 Apr $175 OIH Put @ $10.20
Sell to open 1 Jan $170 OIH Put @ $4.40
Buy to open 1 Apr $165 OIH Put @ $8.50

Net Debit: $20

Adjustment #3 – Change in Greeks

Adjustment #3 – New Risk Graph

DOUBLE DIAGONAL VS IRON CONDOR

The double diagonal option strategy is a neutral options strategy that has a similar payoff diagram to an iron condor. Both Iron Condors and Double Diagonals benefit from time decay, however one of the key differences is that double diagonals are long Vega. In other words, increases in volatility will benefit double diagonals whereas they will hurt iron condors. This is one of the major reasons attractions to this strategy, as a way to diversify some of the vega risk from trading iron condors.

The other way double diagonals differ from iron condors is that you are trading different expiry months. Generally you would set up the double diagonal strategy by selling the near month options and buying options further out-of-the-money AND further out in time.

TURNING A DOUBLE DIAGONAL INTO AN IRON CONDOR

One attraction of the double diagonal is that you can turn it into an iron condor after you close out the front month options. To turn a double diagonal into and iron condor, simply close out the front month options, then sell to open options with the same strike in the same expiry month as the back month options. Voila – you have an iron condor.

Some traders might use this strategy rather than simply selling a long term iron condor. The idea being that you can generate twice the income by selling two lots of options. Your rate of Theta decay will be higher using a double diagonal and turning it in to an iron condor as opposed to simply selling a long term iron condor. This is due to the fact that your short options are always in the front month which experiences the highest rate of Theta decay.

USING DOUBLE DIAGONALS IN A COMBINATION STRATEGY

Double diagonals by themselves may not be an appropriate strategy for you when trading them in isolation. One way to solve this problem is to use them as part of an overall combination strategy. As double diagonal spreads are long Vega, you can use them in conjunction with your iron condors in order to decrease your Vega risk.

Below you see an example of a standard iron condor on RUT with strikes of 750-740 and 870-800 using 10 contracts. You can see that delta is -30, Vega is -207 and Theta is 59. The payoff diagram is that of a standard iron condor.

Jan ’13 RUT iron condor Greeks

Jan ’13 RUT iron condor risk graph

Now, we add a double diagonal to the iron condor as such:

Buy 2 Feb 14 th 730 Puts @ $5.64
Sell 2 Jan 17 th 740 Puts @ 2.92
Buy 2 Feb 14 th 890 Calls @ 3.04
Sell 2 Jan 17 th 880 Calls @ 1.66

Net Debit: $820

We now have the following positions. You can see that delta is the same at -30, Vega is -91 and Theta is 65. So Vega has been reduced from -207 to -91 which is a significant reduction. Theta has been increased from 59 to 65. The ratio of Vega to Theta has reduced from 3.5 to less than 1.5. This was using a ratio of 2 double diagonals for every 10 iron condors, but you can play with the numbers to work out a ratio that works for you. You can also create rules in your trading plan depending on the current level of implied volatility. For example, when volatility is low, you might want to add more double diagonals in order to increase your Vega. The opposite is true when volatility is high, you might want to reduce the number of double diagonals in order to decrease your Vega.

What’s the catch you might be asking? Well, you now have more capital at risk in the trade, with $11,000 at risk now opposed to $8,000. However, the reduced Vega risk may help you sleep a bit better at night. Iron condor traders are always concerned about volatility spikes, so maybe adding a double diagonal or two is the solution you have been looking for.

Looking at the profit graph below, you can see that your income potential if RUT stays exactly where it is, is reduced from $2,000 down to around $1500-$1600, but how often does an underlying stay in exactly the same spot over the course of a month? How often have you had an iron condor position gradually drift up or down towards your short strikes?

SUMMARY

Double diagonals are not a common option strategy, but they are one that many pro traders use. At first glance they might look like a fantastic strategy, but you need to be careful and have a really good understanding of implied volatility and how to manage the position.

When used in isolation, the long Vega exposure might be too much for some traders. However, using them in conjunction with other strategies, might be just the solution you were looking for.

Thanks for reading, now why don’t you go and paper trade some double diagonals and be sure to let me know what you think in the comments below!

How to Manage a Double Diagonal Spread

Risk management is key if your trade starts to move against you

As noted, when trading double diagonal spreads, the enemy is a significant market move. When your short options move in the money (ITM), or threaten to move ITM, the position begins to lose money. That gives the trader two main choices:

The first choice is to do nothing and hope the market reverses direction, or that expiration day arrives before too much damage is done. This is a very poor choice, yet it’s a popular one. Why? It’s often the result of traders not knowing what action to take coupled with the idea of being forced to close the position and accept a loss. Avoiding a loss is the mantra for such traders. This is a dangerous path to follow because losses, although limited, can become large enough to threaten your ability to continue trading.

The second and more effective choice is to take action that reduces position risk and increases the trader’s chances of earning money going forward. Of course, it’s every trader’s goal to earn money, but holding a position with the hope of recovering a loss and eventually breaking even is not a sound policy. It’s far more effective to exit a bad trade and only hold positions that you believe are worth holding — and that includes positions with a good risk/reward profile.

Let’s examine a double diagonal spread that is in trouble and consider some alternatives.

You have this position:

Long 10 INDX Mar 930 Calls
Short 10 INDX Feb 900 Calls

Long INDX Mar 720 Puts
Short INDX Feb 750 Puts

This position was built by selling a call spread and a put spread, but the long option expires one month later than the short option. When INDX moves enough to approach either $750 or $900, this position is almost always losing money.

If you still hold the position as expiration nears, then the position may be profitable as INDX approaches one of the strikes. However, as with other negative gamma trades, this position has suddenly been transformed into a high risk/high reward gamble. Positions in which a trader is short front-month options become very dangerous when expiration is only a few days in the future. Prudent risk management tells the trader to exit before being in that situation. However, as much as I preach that idea, it’s understood that many traders prefer the excitement of collecting that rapid time decay, while ignoring risk.

Unlike an iron condor, in which your long options are too far out of the money (OTM) to be helpful (except to serve their primary purpose, which is to limit losses), with a diagonal position, the long option is very much alive. That’s why there may be a profit when the short option is almost at the money (ATM).

Depending on how far OTM that long option is, and depending on implied volatility levels, this risky situation (near expiration with shorts almost ATM) can show a profit. That should be all the incentive a trader needs to exit the dangerous trade.

In my opinion, whether it’s a profit or loss does not matter. If the position is too risky to hold, then it’s risky to hold and must be closed. Once again, many traders consider only profit/loss.

Note: A continued move in the same direction may result in the short option smashing through the strike price with position deltas quickly moving against you. What appears to be a perfect finish (arrival at expiration) can become an instant nightmare.

Risk Management Techniques

It’s tempting to hold positions all the way through expiration, because when the front-month options expire worthless, good-sized profits may be there for the taking. The conflict is that exiting prior to expiration reduces risk — and for long-term success, less risk is the name of the game. If you cannot stand giving up the chance to earn a large profit, then consider scaling out of the trade, closing a small portion every day as expiration nears.

When the underlying (INDX, an imaginary index, in this example) is approaching the strike price, be ready with a plan made in advance. It’s best to write a trade plan that includes: “I’ll take this protective action if INDX trades at that price.”

At (or before) the first sign of discomfort, make an adjustment to reduce risk, such as:

1. Close a portion of the trade, perhaps 10 to 20%

2. Buy protection with options or spreads

Important: If buying front-month options, protection must be less far OTM than the current short option. The rationale for buying front-month options is that they are less expensive than second month options. When buying insurance, cost must be considered

Example:

For the double diagonal spread above, if upside protection is needed, consider buying:

  • Feb 880 or Feb 890 calls for more protection
  • Feb call spreads: 880/890 or 890/900 for less costly, but limited, protection

Any trade that adds positive delta helps in this scenario (negative delta is needed if the put spread is in trouble). If it adds positive gamma, it’s even better because it makes additional market advances less painful.

When you can fix a position so that it remains within your comfort zone, that is often a better plan than closing the trade. However, please understand there is a huge difference between making an adjustment that allows you to feel comfortable owning the position and forcing an adjustment, hating the position, and desperately trying to recover losses. The latter is the mindset of the trader who is not destined to survive as a trader. Exercise sound risk management and you can plan on enjoying a lengthy trading career.

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