We have seen various types of spreads in the stock market and how to make money using them. Today also, we shall see another spread that many options traders either don't know about or don't use much. The spread we are talking about is named Diagonal spread.
We shall see why the diagonal spreads are the best choice if you want to invest long-term and make monthly cash income. Diagonal Spreads are considered one of the strong, powerful, and flexible spreads for successful trading.
Diagonal spreads are created by entering the long and short positions with two call options and two put options. All these four options contracts have different strike prices and different expiry dates.
This strategy is similar to covered calls with few changes. Take out a few minutes to check those changes and also how they can be beneficial to you.
The name of the strategy:
The diagonal strategy got its name because it combines horizontal and vertical spread. The horizontal spread shows the difference in the expiry date, whereas the vertical spread shows the difference in their strike prices.
Let us make it more clear for you. Options traders need to buy an option contract with many months to expire and simultaneously sell options in the front month. By doing so, you get the benefits of the different strike prices and expiry dates. In other words, Traders select the back-month leg against the front-month leg.
In order to understand and implement the strategy successfully, you must be aware of the concept of differential time value decay. Further, a small reminder about the Diagonal spread strategy can only be a combination of two strike prices that have to be the same, which means out of the total four strike prices, any two must be the same.
Understand the diagonal spread with an example:
Let us take an example of ABC limited stock; suppose you have done various analyses, including the technical analysis, and concluded that ABC stocks would rise for the next few months. So, you entered the diagonal spread. To do so, you bought a Jan call option at a strike price of 425 by paying Rs. 300 and, at the same time, sold the Dec option at a strike price of Rs. 450 for Rs.100 premium. Your net debit would be Rs.200 (Rs.300-100).
Here, with the help of a Rs. 200 debit, you have limited the potential of the stock moving upside along with the downside risk. If the stock of ABC limited stays where they are or between the two strike prices (425 and 450), it would be ideal for you. Now, as the call options have a strike price of Rs. 450 expire worthlessly, you may sell another call option, repeat the above procedure, and get the premium amount as a monthly profit. You can continue this till the long-term calls expire. This is how you take advantage of leveraging the time decay factor of the options. In this way, it is quite similar to the covered calls strategy.
As we know, short-term contracts have a faster time-decay rate as compared to long ones. So, if you sell the short-term contracts and, against them, buy the long-term contracts of the same underlying asset, you are increasing the probability of making more money with the help of varying time decay rates.
The highest risk in these strategies is limited only to the premium paid while entering the position. In the above case, your max loss is Rs. 200 only.
Now that we are clear on the diagonal strategy and it's working, let us also see how and when you need to exit from the strategy. Wait! If I can get the earnings in the form of a monthly premium, why do I need to close or exit the strategy? Learn the answer to this question below.
Closing or exiting from the Diagonal spread:
The best reason you want to close this strategy is that you have already had enough premium/profit and thus need to close voluntarily.
Another reason you are hurrying to close this strategy can be that near-month options are moving towards in-the-money, and you want to avoid the assignments.
Kindly follow the below steps if you are planning to close a diagonal spread:
Enter a buy-to-close (BTC) order for those contracts you hold that are about to expire soon.
There is a rule of thumb to apply in this strategy: first, you must close the short side of the diagonal trade in case of margin requirement.
You should be careful about evaluating the profit potential of your long option and whether there is any further potential remaining to make a profit.
And the last thing you can do is order Sell-to-close (STC) for all the remaining options contracts.
Though the diagonal strategy can be a great strategy for you to add to your list, there are chances that you can make losses. If you are unable to gauge the direction or trend of the market, you may lose your money. Further, if you are a beginner in the options market, this strategy is not recommended, as it includes multiple trades. Multiple trades mean more commission and expenses. It may happen that to earn a profit of Rs. 5, you end up paying expenses of Rs. 10. It is not something that will make you rich overnight.
If you want to implement this strategy for cash flow, you need to be proactive, know how to use the stop losses, know various risk management strategies, and how to hedge the funds in adverse market conditions. If you are good at all of the above, then the chances of your success are doubled.