How to Trade a Double Diagonal Option Spread

When trading option spreads, it is often a good idea to take a closer look at the trade that you are considering and determine whether it has a synthetic equivalent that is easier to understand. It’s a sad but true fact that many beginners trade a strategy without a good understanding of what has to happen for the trade to become profitable or run into trouble. Much of the time that problem can be eliminated by examining the risk profile for an equivalent position.

If you lack experience trading diagonal spreads, you may feel more comfortable by breaking this trade into two familiar positions. This is not necessary, but it is beneficial when learning a new strategy.

This discussion involves double diagonal spreads, or a position that uses both puts and calls. Many traders prefer the simple diagonal spread, which uses either puts or calls.

Double Diagonal Spread Example

Buy 5 XYZ Feb 85 Calls
Sell 5 XYZ Jan 80 Calls

Buy 5 XYZ Feb 70 Puts
Sell 5 XYZ Jan 75 Puts

The characteristics of a double diagonal are:

• The long options expire after the short options
• The long options are farther out of the money than the short options
• The puts and calls each use the same two expiration dates

Synthetic Equivalent of a Double Diagonal

The double diagonal is equivalent to owning an iron condor position plus two calendar spreads. I understand that this sounds complicated. However, if you have experience with both calendars and iron condors, then it becomes easier to understand the double diagonal by thinking of the position as if it were composed of strategies you already use.

Iron Condor Example:

Buy 5 XYZ Jan 85 Calls
Sell 5 XYZ Jan 80 Calls

Buy 5 XYZ Jan 70 Puts
Sell 5 XYZ Jan 75 Puts

However, to open a double diagonal position, you enter the order differently. Instead of buying January options, buy February options with the same strike price. The entire double diagonal spread is traded by entering a single, four-legged order with your broker.

NOTE: You did not really trade an iron condor and two calendars, but the final result is the same as if you did. But it’s a one-step process, thus saving time and commission dollars.

Traders who are familiar with calendar spreads (example: buy an XYZ Feb 85 Call and sell an XYZ Jan 85 Call) know that maximum profits are earned when two conditions are met:

* The front-month expires (or is repurchased at a low price) and the back-month option is not too far out of the money.

* When implied volatility (IV) is higher, option prices are higher. Thus, when it’s time to exit the trade, if IV has increased, the calendar spread becomes more profitable, because you collect a higher premium when selling the back-month options.

Combining What You Already Know

Losses:

The iron condor loses money when either of the short options (Jan 75 put or Jan 80 call) moves into the money. The farther it moves, the larger the loss.

Calendars lose value when the underlying stock moves away from the strike price. The farther it moves, the less the calendar spread is worth. The lone exception occurs when the stock moves lower and IV increases by enough to minimize, or completely offset, the fact that the short-term option has moved into the money.

Gains:

The iron condor earns the maximum profit when all options expire worthless. Obviously that means that the short options are out of the money when expiration arrives.

The calendar spread profits when the front-month options expire worthless and the back-month options are not far out of the money. The IV level plays a big role in the size of the profit, but when both near-term options expire worthless, the two calendars spreads should be profitable.

Conclusion:

The double diagonal spread is very similar to the iron condor and profits when the front-month options expire worthless.

Follow Mark Wolfinger on Twitter @MarkWolfinger.

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