How to Manage a Double Diagonal Spread

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The profit and loss lines are not straight. Straight lines and hard angles usually option trading double diagonal strategy that all options in the strategy have the same expiration date. Both of those strategies are time-decay plays. At first glance, this seems like an exceptionally complicated option strategy.

Typically, the stock will be halfway between strike B and strike C when you establish the strategy. If the stock is not in the center at this point, the strategy will have a bullish or bearish bias. The put you bought at strike A and the call you bought at strike D option trading double diagonal strategy to reduce your risk over the course of the strategy in case the stock makes a larger-than-expected move in either direction.

You should try to establish this strategy for a net credit. So you might choose to run it for a small net debit and make up the cost when you sell the second set of options after front-month expiration. As expiration of the front-month option trading double diagonal strategy approaches, hopefully the stock will be somewhere between strike B and strike C. These options will have the same expiration as the ones at strike A and strike D.

See rolling an option position for more on this concept. This helps guard against unexpected price swings between the close of the market on the expiration date and the open on the following trading day. Option trading double diagonal strategy goal at this point is still the same as at the outset—you want the stock price to remain between strike B and C. Ultimately, you want all of the options to expire option trading double diagonal strategy and worthless so you can pocket the total credit from running all segments of this strategy.

Some investors consider this to be a nice alternative to simply running a longer-term iron condor, because you can capture the premium for the short options at strike B and C twice. Are you getting the feeling that rolling is a really important concept to understand before you run this play? To run this strategy, you need to know how to manage the risk of early assignment on your short options. Some investors may wish to run this strategy using index options rather than options on individual stocks.

It is possible to approximate your break-even points, but there are too many variables to give an exact formula. The sweet spot is not as straightforward as it is with most other plays. That will jack up the overall time value you receive. However, the closer the stock price is to strike B or C, the more you might lose sleep because there is increased risk of the strategy becoming a loser if it continues to make a bullish or bearish move beyond the short strike.

So running this strategy is a lot easier to manage if the stock stays right between strike B and strike C for the duration of the strategy. Potential profit for this strategy is limited to the net credit received for the sale of the front-month options at strike B and strike C, plus the net credit received for the sale of the second round of options at strike B and strike C, minus the net debit paid for the back-month options at strike A and strike D.

If established for a net credit at initiation of the strategy, risk is limited to strike B minus strike A minus the net credit received. If you are able to sell an additional set of options at strikes B and C, deduct this additional premium from the total risk. If established for a net debit at initiation of the strategy, risk is limited to strike B minus strike A plus the debit paid.

Margin requirement is the diagonal call spread requirement or the diagonal put spread requirement whichever is greater. If established for a net credit, the proceeds may be applied to the option trading double diagonal strategy margin requirement.

Keep in mind this requirement is on a per-unit basis. For this strategy, time decay is your friend. Ideally, you want all of the options to expire worthless. That way, you will receive more premium for the sale of the additional options at strike B and strike C. After front-month expiration, the effect of implied volatility depends on where the stock is relative to your strike prices.

If the stock is near or between option trading double diagonal strategy B and C, you want volatility to decrease. In addition, you want the stock price to remain stable, and a decrease in implied volatility suggests that may be the option trading double diagonal strategy. If the stock price is approaching or outside strike A or D, in general you want volatility to increase.

An increase in volatility will increase the value of the option you own at the near-the-money strike, while having less effect on the short options at strikes B and Option trading double diagonal strategy. 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 option trading double diagonal strategy, and may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies.

Implied volatility represents option trading double diagonal strategy 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 option trading double diagonal strategy 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 Setup Buy an out-of-the-money put, strike price A Approx. If the stock price is still between strike price B and strike price C at expiration of the front-month options: Sell another put at strike price B and sell another call at strike price C, with the same expiration as the options at strike price A and strike price D. Break-even at Expiration It is possible to approximate your break-even points, but there are too many variables to give an exact formula.

The Sweet Spot The sweet spot is not as straightforward as it is with most other plays. Maximum Potential Profit Potential profit for this strategy is limited to the net credit received for the sale of the front-month options at strike B and strike C, plus the net credit received for the sale of the second round of options at strike B and strike C, minus the net debit paid for the back-month options at strike A and strike D.

Maximum Potential Loss If established for a net credit at initiation of the strategy, risk is limited to strike B minus strike A minus the net credit received. Ally Invest Margin Requirement Margin requirement is the diagonal call spread requirement or the diagonal put spread requirement whichever is greater.

As Time Goes Option trading double diagonal strategy For this strategy, time decay is your friend.

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To profit from neutral stock price action between the strike prices of the short calls with limited risk. In the example above, a two-month 56 days to expiration Straddle is purchased and a one-month 28 days to expiration 95 — Strangle is sold.

This strategy is established for a net debit, and both the profit potential and risk are limited. The maximum profit is realized if the stock price is equal to the strike price of one of the short options on the expiration date of the short-term options, and the maximum risk is realized if the stock price is equal to the strike price of the straddle and if the straddle is held to its expiration.

This is an advanced strategy because the profit potential is small in dollar terms. The maximum profit is realized if the stock price is equal to the one of the strike prices of the short strangle on the expiration date of the short strangle. With the stock price at the strike price of the short call at expiration of the strangle, for example, the profit equals the price of the long straddle minus the net cost of the diagonal spread including commissions.

This is a point of maximum profit because the long call component of the long straddle has its maximum difference in price with the expiring short call. Similarly, the stock price at the strike price of the short put at expiration of the strangle is a point of maximum profit because the long put component of the long straddle has its maximum difference in price with the expiring short put. It is impossible to know for sure what the maximum profit potential is, because it depends of the price of the long straddle, and that price is subject to the level of volatility which can change.

The maximum risk of a double diagonal spread is equal to the net cost of the spread including commissions. This amount is lost if the stock price is equal to the strike price of the straddle and if the straddle is held to its expiration. In this case, the value of the straddle declines to zero and the full amount paid for the spread is lost.

There are two breakeven points, one above the strike price of the short call and one below the strike price of the short put. Conceptually, a breakeven point at expiration of the short strangle is the stock price at which the price of the long straddle equals the net cost of the spread minus the expiration value of the strangle.

It is impossible to know for sure what the breakeven stock price will be, however, because it depends of the price of the long straddle which depends on the level of volatility. This value was calculated using a standard Black-Scholes options pricing formula with the following assumptions: A double diagonal spread realizes its maximum profit if the stock price equals one of the strike prices of the short strangle on the expiration date of the short strangle.

Typically, the stock price is at or near the strike price of the straddle when the position is established, and the forecast is for neutral price action between the strike prices of the short strangle.

A double diagonal spread is the strategy of choice when the forecast is for stock price action between the strike prices of the short strangle, because the strategy profits from time decay of the short strangle. Unlike a short strangle, however, a double diagonal spread has limited risk if the stock price rises or fall sharply beyond one of the strike prices of the short strangle. The tradeoff is that a double diagonal spread is established for a net debit and has a much lower profit potential profit than a short strangle.

A double diagonal spread must also be closed at or prior to the expiration date of the strangle and, therefore involves more bid-ask spreads and commissions than a strangle. Patience and trading discipline are required when trading double diagonal spreads. Patience is required because this strategy profits from time decay, and stock price action can be unsettling as it rises and falls around one of the strike prices of the short strangle as expiration approaches.

Traders must, therefore, enter limit-price orders when entering and exiting a double diagonal spread position. Long calls and short puts have positive deltas, and long puts and short calls have negative deltas. If the stock price is close to the strike price of the straddle when a double diagonal spread is first established, the net delta is close to zero.

With changes in stock price and passing time, however, the net delta varies from slightly positive to slightly negative, depending on the relationship of the stock price to the strike prices of the short options and on the time to expiration of the short strangle. Double diagonal spreads are highly sensitive to volatility. It is therefore necessary to forecast that volatility not fall when using this strategy.

Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. Long options, therefore, rise in price and make money when volatility rises, and short options rise in price and lose money when volatility rises.

When volatility falls, the opposite happens; long options lose money and short options make money. Since vegas decrease as expiration approaches, a double diagonal spread has a net positive vega. Consequently, rising volatility helps the position and falling volatility hurts.

The vega is highest when the stock price is equal to the strike price of the long straddle and is only slightly lower when the stock price is equal to the one of the strike prices of the short strangle. The net vega approaches zero if the stock price rises or falls sharply beyond one of the strike prices of the short strangle. At that point, one long option and one short option are both deep in the money, and the other options are far out of the money.

The vegas of the out-of-the-money options are close to zero, and the vegas of the in-the-money options are approximately equal and opposite and, therefore, offsetting. Consequently, the net vega of the entire double diagonal spread is zero.

This is known as time erosion. Long option positions have negative theta, which means they lose money from time erosion, if other factors remain constant; and short options have positive theta, which means they make money from time erosion. A double diagonal spread has a net positive theta as long as the stock price is in a range between the strike prices of the short strangle. This means that a double diagonal spread profits from time decay.

If the stock price rises or falls beyond a breakeven point, then the theta approaches zero. At such a stock price, however, a double diagonal spread has undoubtedly reached the point of maximum risk. Stock options in the United States can be exercised on any business day, and holders of short stock option positions have no control over when they will be required to fulfill the obligation.

Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options. While the long call and long put in a double diagonal spread have no risk of early assignment, the short call and put do have such risk.

Early assignment of stock options is generally related to dividends. Short calls that are assigned early are generally assigned on the day before the ex-dividend date, and short puts that are assigned early are generally assigned on the ex-dividend date.

In-the-money calls and puts whose time value is less than the dividend have a high likelihood of being assigned. If the short call is assigned, then shares of stock are sold short and the long call remains open.

If a short stock position is not wanted, it can be closed in one of two ways. First, shares can be purchased in the market place. Second, the short share position can be closed by exercising the long call. Remember, however, that exercising a long call will forfeit the time value of that call.

Therefore, it is generally preferable to buy shares to close the short stock position and then sell the long call. This two-part action recovers the time value of the long call. One caveat is commissions. Buying shares to cover the short stock position and then selling the long call is only advantageous if the commissions are less than the time value of the long call. If the short put is assigned, then shares of stock are purchased and the long put remains open.

If a long stock position is not wanted, it can be closed in one of two ways. First, shares can be sold in the marketplace. Second, the long share position can be closed by exercising the long put. Remember, however, that exercising a long put will forfeit the time value of that put. Therefore, it is generally preferable to sell shares to close the long stock position and then sell the long put.

This two-part action recovers the time value of the long put. Selling shares to close the long stock position and then selling the long put is only advantageous if the commissions are less than the time value of the long put.

Note, however, that whichever method is used, trading stock or exercising a long option, the date of the stock purchase or sale will be one day later than the date of the short sale or purchase. This difference will result in additional fees, including interest charges and commissions. Assignment of a short option might also trigger a margin call if there is not sufficient account equity to support the stock position created. The position at expiration of the short strangle depends on the relationship of the stock price to the strike prices of the short options.

If the stock price is at or between the strike prices of the short strangle, then the both short options expire worthless and the long straddle remains open.

If the stock price is above the strike price of the short call, however, then the short call is assigned. The result is a three-part position consisting of a long call, a long put and short shares of stock. If the stock price is above the strike price of the short call immediately prior to its expiration, and if a position of short shares is not wanted, then the short call must be closed.

If the stock price is below the strike price of the short put, then the short put is assigned. The result is a three-part position consisting of a long put, a long call and long shares of stock. If the stock price is below the strike price of the short put immediately prior to its expiration, and if a position of long shares is not wanted, then the short put must be closed.

Double diagonal spreads can be described in two ways. First, as described here, they are the combination of a longer-term straddle and a shorter-term strangle. Second, they can also be described as the combination of a diagonal spread with calls and a diagonal spread with puts in which the long call and long put have the same strike price. Strike prices were listed vertically in rows, and expirations were listed horizontally in columns. The commissions for four options, and potentially more options if some are exercised or assigned, could have a significant effect on the potential profit of this strategy.

A long — or purchased — straddle is a strategy that attempts to profit from a big stock price change either up or down. A short strangle consists of one short call with a higher strike price and one short put with a lower strike. Reprinted with permission from CBOE. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.

Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk.