What is Double Diagonal?
Derivative trading is one of the most rewarding asset classes for investors who have allocated some capital to equities. Professional investors choose Options contracts within derivatives to ensure they remain liquid and make profits in almost every market situation. Among various strategies used by options traders to make profits, one of the most complex yet rewarding is a double diagonal options trading strategy.
This article explains what a double diagonal is and how you can use the strategy to improve your portfolio’s health. But first a little about the basic terms associated with the double diagonal options trading strategy.
What are the Options?
An option is a financial contract that gives you the right but not the obligation to buy or sell an underlying asset at a predetermined price in the future. To enter into an option contract, you have to pay a premium, but you are not under any obligation to exercise the contract. You can either sell the contract at a future date or allow it to expire if it’s not favorable and will result in a loss. Options with stock and indices as underlying assets are most actively traded in the Indian derivatives market.
Two types of options
Options are of two types:
- Call option: A call option gives you the right but not the obligation to buy an underlying asset such as stock or stock indices at an agreed-upon price and before a set future date known as the expiration date.
- Put option: A put option gives you the right but not the obligation to buy an underlying asset at an agreed-upon price at or before the expiration date. Remember that traders or speculators don’t have to buy the underlying asset; they can profit by selling the option contract at a higher price before or at the expiration date.
Terms associated with Double Diagonal: What you need to know
- Strike Price: The price at which the options contract was initially bought or the pre-determined price.
- Spot Price: The current price of the underlying asset that is attached to the options contract.
- Premium: It is the price you pay to the seller of the option for entering into the online trading options.
- In-The-Money (ITM) option: When the underlying asset price is higher than the strike price.
- Out-of-the-money (OTM) option: When the underlying asset price is lower than the strike price.
- Long Straddle: A strategy that makes profits from a steep change in the stock’s price, either up or down.
- Short Strangle: A strategy that has one short put with a lower strike price and one short call with a higher strike price.
What is Diagonal Call Spread?
A diagonal call spread is an options strategy that is often called a poor man's covered call. They are financial transactions where the investor selling the call options owns the same amount of underlying security to reduce the risk factor by a huge margin. The diagonal spread is initiated by buying a long in-the-money call and simultaneously selling a short in-the-money call option.
What is a Diagonal Put Spread?
There are two types of diagonal put spread. The first is initiated when the investor buys a long in-the-money put option and simultaneously sells a short out-of-the-money put option. The second type is where the investor sells a short out-of-the-money put option and simultaneously buys a long further out-of-the-money put option.
What is a double diagonal options trading strategy?
A double diagonal options trading strategy is an advanced options trading strategy where the investor combines a diagonal call spread with a diagonal put spread that benefits from the time decay. It is also represented by buying one long straddle and selling one short strangle.
The time decay is the measure of the rate by which the value of an options contract declines as the expiry date of the options contract nears. For the double diagonal options trading strategy, time decay is beneficial as the investors want the options to expire worthlessly. The aim of executing a double diagonal options trading strategy is to ensure that the front-month options decay faster than the back-month options contracts.
The double diagonal options trading strategy is executed to earn the net debit arising out of the premium amount for all the options contracts. In double diagonal options trading strategy, both the risk and profit potential are limited. The double diagonal strategy is considered to be an advanced and complicated options strategy as the profit potential is small and requires the trader to trade a large number of spreads.
Maximum profit potential
In the double diagonal options trading strategy, the maximum profit is realized when the stock price is equal to one of the short strangle’s strike prices at the expiration date. It is because when the stock price is equal to the strike price, the profit becomes the same as the difference between the price of the long straddle and the net cost of the diagonal spread plus commissions. Maximum profit is achieved as the long call of the long straddle is at its maximum price difference with the expiring short call. Furthermore, maximum profit is also achieved when the long put option of the long straddle has its maximum price difference with the expiring short put.
Maximum Loss/Risk
The maximum risk in the double diagonal options trading strategy is the maximum amount of net cost of all the spreads plus commissions. The investor incurs maximum loss if the loss price becomes equal to the strike price of the straddle and the investor holds the straddle until expiry.
How implied volatility impacts double diagonals?
Volatility is the percentage measure of how much a stock price fluctuates and its effect on the options’ price. As volatility rises, it forces the price of the options contract to rise, given the stock price and the expiration date are constant. For long options, this volatility increases the prices and the investors make profits. However, for short options, the volatility results in increasing the prices, and the investors lose money in this case. When volatility falls, the opposite of the above situation happens where long options result in losses while short options make profits for the investors.
‘Vega’ is the measure of how much volatility affects the prices of the options contract. Since vega or implied volatility decreases with a nearing expiration date, the double diagonal results in net positive vega, giving profits. As long as implied volatility rises, the position is profitable, if volatility falls, losses follow.
Other Considerations: Conclusion
A double diagonal options trading strategy can be executed in two ways. The first one includes combining a longer-term straddle and a shorter-term strangle. The second is by combining a diagonal spread with put options and a diagonal spread with call options in which the long call and long put have the same strike price.
Although the double diagonal options trading strategy can offer high profits to the investors, it is one of the most complicated options strategies. Therefore, it is important that you first understand everything about the double diagonal options trading strategy. It is also advisable that you execute the double diagonal options trading strategy in demo trading platforms before executing it with real money in live markets. If you have any other queries regarding double diagonal and other options strategies, you can always read other derivative blogs on the IIFL website.
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Frequently Asked Questions
Yes diagonal spreads are profitable and maximum profit is achieved when the stock price is equal to one of the short strangle’s strike prices at the expiration date, The double diagonal is also profitable when the long put option of the long straddle has its maximum price difference with the expiring short put.
You can stop a diagonal spread by closing the position after the expiration of the short option. Furthermore, the position can also be stopped by replacing the expired option with a new option having the same strike price but with the expiration of the longer option (or earlier).
Diagonal debit spread is when the trader enters for a net debit and makes a profit. This is when the trader covers up the debit after selling back month options after the front-month options.
Diagonal put is when the investor buys a long-term in-the-money put option and simultaneously sells a short-term out-of-the-money put option. Alternatively, an investor sells a short-term out-of-the-money put option and simultaneously buys a long-term further out-of-the-money put option.