Recommended Option Strategies: Double Diagonal Spreads

Double diagonal spreads are
similar to iron condors, with one significant difference:  the options you buy expire after the options you sell.  Thus, a double diagonal spread is equivalent
to buying an iron condor and buying two calendar (time) spreads.

Definition
of a calendar spread:  A position consisting of two options of the
same type (both calls; or both puts), on the same underlying, with the same
strike price.  The options have different
expiration dates.  When you buy the calendar spread, you own the
option that expires later.  You must pay
a debit to own the calendar spread.  When
you sell the calendar spread, you own
the option that expires earlier and collect a cash credit.

The
idea behind this strategy is that the calendar spread tends to increase in
value as time passes and the
underlying asset moves towards the strike price.  It’s not ‘easy  money’ because when the underlying moves away
from the strike price, the investor often loses money.  This is a very popular strategy among
individual investors.

When a situation calls for a
calendar spread, I prefer to trade a double
diagonal
instead.  That strategy is
the same as owning an iron condor with two calendar spreads:

Reminder:
You can find a description of an iron condor here, with additional
details here.

Example
of a double diagonal spread:

Sell
5 ZYY Apr 80 calls; Buy 5 ZYY May 85 calls; and

Sell
5 ZYY Apr 65 puts; Buy 5 ZYY May 60 puts

Note:  If you bought Apr 85 calls and Apr 60 puts (instead of the May options), you
would own an iron condor.

When you buy the iron condor,
you always collect cash.  When you buy
the double diagonal spread, sometimes you pay cash and sometimes you collect
cash.  Why? You collect cash when selling
the call and put credit spreads, but you pay cash for the calendar
spreads.  Sometimes the calendars cost
more than the credit spreads and sometimes they cost less.

As with an iron condor, this
position earns the largest profit when the near-term options expire
worthless.  At that time, you sell your
long calls and generate cash.  When that
cash is more than the cost to open the double diagonal spread, you have a
profit.

When you buy a double diagonal
spread, when the near-term options expire (or are
repurchased),
you still own options.  The value of those options
depends on two factors:

  •       
    How far out of
    the money they are
  •        
    More importantly,
    the implied volatility (IV) of the options.


IV is a topic we have not yet
covered on this blog, but you can find an explanation geared to option rookies here.  In a nutshell, the more volatile the market
is expected to be – before the options expire, the higher the price of options – both calls
and puts.  Thus, if IV is relatively high,
you sell your options at a relatively high price.  Similarly, a low IV environment means you
will receive less when selling your options. 
This dependence on IV makes it difficult to estimate the maximum
potential profit for a double diagonal spread.

NOTE:  It’s not necessary to trade a double
diagonal.  If your intention is to sell a
call spread or a put spread (instead of an iron condor), you can choose the
simple diagonal spread. 

Example:

Sell
8 WXY Dec 220 calls

Buy
8 WXY Jan 240 calls

Diagonal and double diagonal
spreads are attractive when you believe implied volatility is low, and will
be higher in the near future.  Otherwise,
it’s less risky to trade the iron condor.

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