Diagonal Spread Trading Rules
Unlike the short vertical spreads that have long been the bread-and-butter of my trading, diagonal spreads work well regardless of the implied volatility rank. They’re a good alternative to short vertical spreads in periods when IVR is low across the market.
A long diagonal spread is built from a short option closer in time and a long option with a different strike further out in time. If the options are calls, then the position is bullish. If puts, then bearish.
Here are the rules:
- Buy a long option
- 90 to 120 days before expiration
- Delta around 80
- Sell a short option
- 30 to 60 days before expiration, with 45 days being optimal
- Delta 30 to 50
- Ensure that the premium of the short option is equal to or greater than the extrinsic value of the long option. This becomes easier to obtain the deeper in the money the long options is placed.
- Ensure that the net debit is around 50% of the spread and that it never exceeds 75% of the width.
- Exit for a win if the stock price moves significantly in the direction of the trade, rises (for calls) or falls (for puts).
- Roll the short option to a lower strike (for calls) or higher strike (for puts) if the share price moves significantly against the direction of the trade. (“Significantly” is undefined; I look at the potential loss, the trend on the chart, and then follow my intuition.)
Although maximum profit cannot be determined precisely, it can be estimated by subtracting the net debit paid from the width of the strikes.
The breakeven point can be calculated by subtracting the net debit paid from the long strike price.
By Tim Bovee, August 8, 2021, Portland, Oregon
Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.
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Based on a work at www.timbovee.com.