Trading Diagonal Spreads

diagonal spreads

Diagonal

A Long Put Diagonal Spread is the combination of a long put vertical spread and a put calendar spread.

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.

Use this strategy when you have a bearish direction assumption. Typically we set up these kind of strategies only when Implied Volatility is low and when we want to do a directional play.

 

How do you set up a Diagonal Spread

Typically we don’t use this strategy much because you have to pay for it and you have to be directional right. We enter this trade when volatility of the stock is low.

  • Buy an in-the-money (ITM) put option in a longer-term expiration cycle (Expiration 2)
  •  Sell an out-of-the-money (OTM) put option in a near-term expiration cycle (Expiration 1)

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.

Let us give an example:

  • XYZ Stock at $100
  • Purchase (Expiration 2 June) 110 put for $15
  • Sell (Expiration 1 may) 90 put for $5.00
  • Net debit = $10.00 on a 20-point-wide long put diagonal spread

Maximum Profit: 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 formula: Width of put strikes – net debit paid

How to Calculate Break-even(s): 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 formula: Long put strike price – net debit paid

Approach to Diagonal Spreads

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. For this trade we have to pay $9.58

We never route diagonal spreads in volatility instruments. Each expiration acts as its own underlying, so our maximum loss is not defined.

 

Manage Diagonal Spreads?

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 break even price, so that we can collect more premium and reduce our overall risk.

Close Diagonal Spread

When do we close Diagonal Spreads? We generally look for 25-50% of maximum profit when closing diagonal spreads. Profit occurs when the long option moves further ITM and gains value, and/or if implied volatility increases.

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