In today's video tutorial, I want to talk about how to setup and trade a diagonal call spread. You can think of call diagonals as a two-part strategy. That’s because it's basically a cross between a long calendar spread and a short credit call spread, so both of those long calendar spread and a short credit call spread.
Having features of both of these basic strategies, this is a more advanced strategy that profits from both the decay in the option prices and the differential between the contract months and the downward directional movement of the underlying stock. How do we setup this strategy?
The first thing that we’re going to do is we're going to sell one out of the money front month call. This would be a front month option about 20 to 45 days out. We don’t want to get closer or longer than that.
The next thing we’re going to do is we’re going to buy an out of the money back-month call, but this time, this is where it differs from a regular calendar spread, is that we’re going to go to a higher strike price.
Two things are happening here. We’re trading two different contract months, both the front month call and a back-month call and we’re trading two different strike prices. It gets a little confusing sometimes, but use this guide as your resource when you’re creating these strategies.
What’s the risk? If established for a net credit, the risk is limited to the difference between the strike prices minus the net credit received.
If you are establishing this position for a net debit which is usually the case of establishing some of these diagonals, the risk is limited to the difference between the strike prices plus the net debit that you paid. The profit potential for these strategies can vary because of the decay in the back month option you’re long.
These options have different decay and time factors, so we don't know exactly where that profit is going to land, but we do know that most of the time, your profit is limited to the net credit received from selling the front month option minus the premium bought for that back-month put option.
As far as volatility is concerned, increasing volatility definitely helps these positions. It has a positive impact on the strategy.
This is the reason why we want to trade these strategies only when implied volatility is very, very low because volatility tends to show a greater boost in value of that back month option that we’re long, that call option we’re long and the back month compared to the negative impacts of that front month option that we are short.
As far as the passage of time goes and Theta decay, it generally helps this position because we’re looking to collect the value of that front month option that we sold. The closer we get to expiration, the faster our profit materializes.
Breakeven points on diagonal spreads are a little bit harder to calculate, there's no single way to do it. What we always say is that it’s important that you analyze a trade first before you place an order.
We’re going to do that right now on our broker platform on Thinkorswim. We're going to look at SPY which is currently open and trading.
It’s trading for about 203.37 right now and what we’re going to do is create a call diagonal spread that’s going to be a little bit bearish tilt in how we think SPY is going to trade over the next month or so.
What we’re going to do is we’re going to focus on trading just the February monthly contracts and the March contracts which have 57 days to go. You can see the February options are going to be our front month options.
They’re closer to where expiration is and the March options are going to be our back month options. The first thing that we want to do is we want to trade this a couple of strikes out of the money with our front-month option.
What we’re going to do is we’re going to focus on the front month in selling the 204 calls. Those are just a little bit above where the market is. In the back month, we’re not going to do the 204s because that would be a calendar.
We’re going to go out to the 205s and we’re going to buy those 205s. What we did here is we sold the front month option 204 strike prices and we went out to the back month and bought the 205s which is one strike higher.
You can see that that price right now is about $.75. That's how much it's going to cost us to get into this diagonal spread. When we go to the risk profile, you can see that it generally looks like what we had on the screen.
It has a very similar shape as a calendar, but there’s less risk to the downside here because we’re playing this a little bit directional like a credit call spread above the market.
With the stock trading just about 203 right now, you can see it's got a very wide profit window, but definitely a little bit directionally bearish on this trade because if the stock goes down, we have a tendency to lose less money in this particular case.
If you wanted to create a higher credit on the bottom side of the trade, basically what you would do is you would take your long strike in March and you would move it further out of the money.
I’m going to do this in a really extreme example here. But you can see that if we move this strike all the way out to 209 from 205, this leaves us with a massive, massive credit of $1.12.
You can see now, we are definitely directionally bearish on the stock, this is exactly the direction that we want it to move and it’s much, much closer payoff diagram wise to just a regular credit call spread.
You can see by doing this, we also added additional risk in case the stock does move higher. There’s a little bit of a sweet spot here where you want to take in a credit, but you don’t want to take in too much of a credit and get super directional in this trade.
As far as key takeaways go, these are low implied volatility strategies that work best when you have more of a directional assumption for the underlying stock. We do prefer to enter these trades for a net credit, but a small net credit because this minimizes the directional risk in the security.
We always suggest that you close these spreads completely at the front-month expiration whenever possible and this in our case would be the February expiration. We don’t want to hold this all the way through March expiration.
We want to target it for February expiration, that’s why you give yourself enough time in that front month contract and then close the position out before expiration.
As always, I hope you guys enjoy these video tutorials. If you have any comments or questions, please ask them right below on the lesson page. Until next time, happy trading!