Double Diagonal

The setup

Buy an out-of-the-money put, strike price A (Approx.60 days from expiration — “back-month”)
Sell an out-of-the-money put, strike price B (Approx.30 days from expiration — “front-month”)
Sell an out-of-the-money call, strike price C (Approx.30 days from expiration — “front-month”)
Buy an out-of-the-money call, strike price D (Approx.60 days from expiration — “back-month”)
Generally, the stock price will be between strike price B and strike price C.

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.

The strategy

At the outset of this strategy, you’re simultaneously running a diagonal call spread and a diagonal put spread. Both of those strategies are time-decay plays. You’re taking advantage of the fact that the time value of the front-month options decay at a more accelerated rate than the back-month options

At first glance, this seems like an exceptionally complicated option strategy. But if you think of it as capitalizing on minimal stock movement over multiple option expiration cycles, it’s not terribly difficult to understand how it works.

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. You want the stock to remain between strike B and strike C, so the options you’ve sold will expire worthless and you will capture the entire premium. The put you bought at strike A and the call you bought at strike D serve 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. But you may not be able to do so because the front-month options you’re selling have less time value than the back-month options you’re buying. 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 options approaches, hopefully the stock will be somewhere between strike B and strike C. To complete this strategy, you’ll need to buy to close the front-month options and sell another put at strike B and another call at strike C. These options will have the same expiration as the ones at strike A and strike D. This is known as “rolling” out in time. See rolling an option position for more on this concept.

Most traders buy to close the front-month options before they expire because they don’t want to carry extra risk over the weekend after expiration. 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.

Once you’ve sold the additional options at strike B and strike C and all the options have the same expiration date, you’ll discover you’ve gotten yourself into a good old iron condor. The 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 out-of-the-money 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.

Options guys tips

For this Playbook, I’m using the example of a double diagonal with options 30 and 60 days from expiration. However, it is possible to use back-month options with an expiration date that’s further out in time. If you’re going to use more than a one-month interval between the front-month and the back-month options, you need to understand the ins and outs of rolling an option position.

Whenever you’re short options, you have to be extremely careful during the last week prior to expiration. In other words, if one of the front-month options you’ve sold is in-the-money during the last week, it will increase in value much more rapidly than the back-month options you bought. (That’s why this period is sometimes referred to as “gamma week.”) So if it appears that a front-month option will expire in-the-money, you may wish to consider rolling your position before you reach the last week prior to expiration. 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. That’s because historically, indexes have not been as volatile as individual stocks. Fluctuations in an index’s component stock prices tend to cancel one another out, lessening the volatility of the index as a whole.

Who should run it

All-Stars only

NOTE: Due to the significant risk if the stock moves sharply downward, this strategy is suited only to the most advanced option traders. If you are not an All-Star trader, consider running a skip strike butterfly with puts.

When to run it

You’re anticipating minimal movement on the stock over at least two option expiration cycles.

Break-even at expiration

It is possible to approximate your break-even points, but there are too many variables to give an exact formula.

Because there are multiple expiration dates for the options in this strategy, a pricing model must be used to “guesstimate” what the value of the back-month options will be when the front-month options expire. Use the Profit + Loss Calculator to help in this regard. But keep in mind, the Profit + Loss Calculator assumes that all other variables such as implied volatility , interest rates, etc. remain constant over the life of the trade, and they may not behave that way in reality.

The sweet spot

The sweet spot is not as straightforward as it is with most other plays. You might benefit a little more if the stock winds up at or around strike B or strike C at the front-month expiration because you’ll be selling an option that’s closer to being at-the-money. 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.

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.

NOTE: Because you don’t know exactly how much you’ll receive from the sale of the additional options at strikes B and C, you can only “guesstimate” your potential profit when establishing this strategy.

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. 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. If you are able to sell an additional set of options at strikes B and C, deduct this additional premium from the total risk.

NOTE: You can’t precisely calculate your risk at initiation of this strategy, because it depends on the premium received (if any) for the sale of the additional options at strikes B and C.

Margin requirement

Margin requirement is the diagonal call spread requirement or the diagonal put spread requirement(whichever is greater).

NOTE: If established for a net credit, the proceeds may be applied to the initial margin requirement.

Keep in mind this requirement is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.

As time goes by

For this strategy, time decay is your friend. Ideally, you want all of the options to expire worthless.

Implied volatility

After the strategy is established, although you don’t want the stock price to move much, it’s desirable for volatility to increase around the time the front-month options expire. 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 strikes B and C, you want volatility to decrease. This will decrease the value of all of the options, and ideally, you’d like everything to expire worthless. In addition, you want the stock price to remain stable, and a decrease in implied volatility suggests that may be the case.

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 C.

Buying the put gives you the right to sell the stock at strike price A. Selling the call obligates you to sell the stock at strike price A if the option is assigned. This strategy is often referred to as “synthetic short stock” because the risk / reward profile is nearly identical to short stock.

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Buying the call gives you the right to buy stock at strike price A. Selling the two calls gives you the obligation to sell stock at strike price B if the options are assigned. This strategy enables you to purchase a call that is at-the-money or slightly out-of-the-money without paying full price.

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Front Spread w/Puts

Buying the put gives you the right to sell stock at strike price B. Selling the two puts gives you the obligation to buy stock at strike price A if the options are assigned. This strategy enables you to purchase a putth at is at-the-money or slightly out-of-the-money without paying full price.

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Double Diagonal

At the outset of this strategy, you’re simultaneously running a diagonal call spread and a diagonal put spread . Both of those strategies are time-decay plays. You’re taking advantage of the fact that the time value of the front-month options decay at a more accelerated rate than the back-month options...

Learn More

Double Diagonal

The setup

The strategy

Options guys tips

Who should run it

When to run it

Break-even at expiration

The sweet spot

Maximum potential profit

Maximum potential loss

Margin requirement

As time goes by

Implied volatility

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