Option Strategies
Long Diagonal Spreads

Principles you need to know before you begin this journey

  • A Long Call Diagonal Spread is constructed by purchasing a call far out in time, and selling a near term call on a further OTM strike to reduce cost basis. This trade has only two legs, but it gives the effect of a long vertical spread in terms of directionality, and a calendar spread in terms of its positive vega. This results in a bullish position that can benefit from an increase in implied volatility. A Long Call Diagonal Spread is usually used to replicate a covered call position. 

– Buy an in-the-money (ITM) call option in a longer-term expiration cycle (Expiration 2) 

– Sell an out-of-the-money (OTM) call option in a near-term expiration cycle (Expiration 1) 

  

The trade will be entered for a debit. It’s important that the debit paid is no more than 75% of the width of the strikes. 

  

Example: 

XYZ Stock at $100 

Purchase (Expiration 2) 90 call for $15 

Sell (Expiration 1) 110 call for $5 

Net debit = $10.00 on a 20-point-wide long call diagonal spread 

 

The setup of a diagonal spread is very important.  

 

If we have a bad setup, we can actually set ourselves up to lose money if the trade moves in our direction too fast.  

 

To ensure we have a good setup, we check the extrinsic value of our longer dated ITM option. 

 

Once we figure that value, we ensure that the near term option we sell is equal to or greater than that amount.  

 

The deeper ITM our long option is, the easier this setup is to obtain. We also ensure that the total debit paid is not more than 75% of the width of the strikes. 

 

  

 

We never route diagonal spreads in volatility instruments. Each expiration acts as its own underlying, so our max loss is not defined. 

Max Profit: The exact maximum profit potential cannot be calculated due to the differing expiration cycles used. However, the profit potential can be estimated with the following formula: 

Width of call strikes – net debit paid 

How to Calculate Breakeven(s): The break-even cannot be calculated due to the differing expiration cycles used in the trade. As a rough estimate, the break-even area can be approximated with the following formula: 

Long call strike price + net debit paid 

 When do we close Diagonal Spreads? 

We generally look for 25-50% of max profit when closing diagonal spreads. Profit occurs when the long option moves further ITM and gains value, and/or if implied volatility increases. 

When do we manage Diagonal Spreads? 

We manage diagonal spreads when the stock price moves against our spread. In this case, we look to roll down the short option closer to the breakeven price, so that we can collect more premium and reduce our overall risk.  

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Option Strategies
Mindset of Setting Up an Option

Principles you need to know before you begin this journey

Identify what kind of trader you want to be.

  • A Long Call Diagonal Spread is constructed by purchasing a call far out in time, and selling a near term call on a further OTM strike to reduce cost basis. This trade has only two legs, but it gives the effect of a long vertical spread in terms of directionality, and a calendar spread in terms of its positive vega. This results in a bullish position that can benefit from an increase in implied volatility. A Long Call Diagonal Spread is usually used to replicate a covered call position. 

– Buy an in-the-money (ITM) call option in a longer-term expiration cycle (Expiration 2) 

– Sell an out-of-the-money (OTM) call option in a near-term expiration cycle (Expiration 1) 

  

The trade will be entered for a debit. It’s important that the debit paid is no more than 75% of the width of the strikes. 

  

Example: 

XYZ Stock at $100 

Purchase (Expiration 2) 90 call for $15 

Sell (Expiration 1) 110 call for $5 

Net debit = $10.00 on a 20-point-wide long call diagonal spread 

 

The setup of a diagonal spread is very important.  

 

If we have a bad setup, we can actually set ourselves up to lose money if the trade moves in our direction too fast.  

 

To ensure we have a good setup, we check the extrinsic value of our longer dated ITM option. 

 

Once we figure that value, we ensure that the near term option we sell is equal to or greater than that amount.  

 

The deeper ITM our long option is, the easier this setup is to obtain. We also ensure that the total debit paid is not more than 75% of the width of the strikes. 

 

  

 

We never route diagonal spreads in volatility instruments. Each expiration acts as its own underlying, so our max loss is not defined. 

Max Profit: The exact maximum profit potential cannot be calculated due to the differing expiration cycles used. However, the profit potential can be estimated with the following formula: 

Width of call strikes – net debit paid 

How to Calculate Breakeven(s): The break-even cannot be calculated due to the differing expiration cycles used in the trade. As a rough estimate, the break-even area can be approximated with the following formula: 

Long call strike price + net debit paid 

 When do we close Diagonal Spreads? 

We generally look for 25-50% of max profit when closing diagonal spreads. Profit occurs when the long option moves further ITM and gains value, and/or if implied volatility increases. 

When do we manage Diagonal Spreads? 

We manage diagonal spreads when the stock price moves against our spread. In this case, we look to roll down the short option closer to the breakeven price, so that we can collect more premium and reduce our overall risk.  

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Mindset of Setting Up a Trade

Identify what kind of trader you want to be.

  • Make a killing
  • Casual earnings
  • Safe and steady

Identify an underlying stock you want to trade

  • Trade actual stocks
  • Trade ETFs
  • Best of you are already familiar with the behavior of the stock or ETF as they all have their own personalities

Need to be able to read a chart to determine direction

  • Support and Resistance
  • Fibonacci Retracements and Extensions
  •  Candlestick patterns
  • Indicators

        •  MACD
        • Volume
        • RSIs
        • TTSqueeze
        • Bollinger Bands
        • Keltner Funnels

Considerations in Placing the Trade

  • Volatility of the Market reflects premium
  • Implied volatility or volatility rank of the stock reflects premium
  • Strike width
  • Strike expiration
  • At the money, in the money, or out of the money
  • Understand management strategies
  • Profit goals

Identify what kind of trader you want to be.

  • Make a killing
  • Casual earnings
  • Safe and steady

Identify the strategies that you are comfortable with.  Can you use these strategies to implement your trading mindset

Make a killing

  • Buy and sell puts and calls – most aggressive
  • Debit vertical spreads – aggressive
  • Straddles
  • Strangles

Casual Earnings

  • Vertical call or put credit spreads
  • Iron condors
  • Iron butterflies

Safe and Steady

  • Covered calls
  • Covered puts

Identify an underlying stock you want to trade

  • Trade actual stocks
  • Trade ETFs
  • Best of you are already familiar with the behavior of the stock or ETF as they all have their own personalities

Trade ETFs

  • Less volatile with less swings
  • More frequent expirations 

Trade actual stocks

  • Can be significantly more volatile
  • Need to consider earnings dates
  • Need to consider distributions
  • Need to consider whimsical events on part of company

Identify an underlying stock you want to trade

  • Trade actual stocks
  • Trade ETFs
  • Best of you are already familiar with the behavior of the stock or ETF as they all have their own personalities

Trade ETFs

  • Less volatile with less swings
  • More frequent expirations 

Trade actual stocks

  • Can be significantly more volatile
  • Need to consider earnings dates
  • Need to consider distributions
  • Need to consider whimsical events on part of company

Need to be able to read a chart to determine direction

  • Support and Resistance
  • Fibonacci Retracements and Extensions
  •  Candlestick patterns
  • Indicators

        •  MACD
        • Volume
        • RSIs
        • TTSqueeze
        • Bollinger Bands
        • Keltner Funnels

Support and Resistance

  • Less volatile with less swings
  • More frequent expirations 

Fibonacci Retracements and Extensions

  • Can be significantly more volatile
  • Need to consider earnings dates

Candlestick Patterns

  • Can be significantly more volatile
  • Need to consider earnings dates

Moving Averages

  • Can be significantly more volatile
  • Need to consider earnings dates

MACD

  • Can be significantly more volatile
  • Need to consider earnings dates

Volume

  • Can be significantly more volatile
  • Need to consider earnings dates

TT Squeeze

  • Can be significantly more volatile
  • Need to consider earnings dates

Bollinger Bands

  • Can be significantly more volatile
  • Need to consider earnings dates

Kelner Funnels

  • Can be significantly more volatile
  • Need to consider earnings dates

Placing The Options Trade

  • Consider the environment in terms of volatility. High volatility environments will increase the premiums.  Elevated volatility environments are more optimal to sell premium
  • Choose a strategy based on your feeling about what you predict to be the direction and strength of the stocks movement.  Buying and selling puts ( and therefore straddles and strangles ) for a debit are aggressive strategies.  Buying and selling credit spreads ( and therefore butterflies and condors are less aggressive )
  • Consider extrinsic value of the conditions
  • Determine the month of expiration
  • Determine the width of the strikes

Consider the environment in terms of volatility

  • Less volatile with less swings
  • More frequent expirations 

Strategy considerations if you are very sure about direction and strength of a stock move

  • Buy a call or put for a debit
  • Buy a straddle or a strangle for a debit
 
  • If you are less than VERY sure, you will want to consider hedging your bet by placing a credit or debit spread strategy that will limit any potential losses keeping in mind that it also limits your profit potential.
 

Strategy considerations if you are less than VERY sure about direction and strength of a stock move

  • Buy or Sell a credit spread
  • Buy or Sell a iron butterfly or iron condor
  • If you are less than VERY sure, you will want to consider hedging your bet by placing a credit or debit spread strategy that will limit any potential losses keeping in mind that it also limits your profit potential.

Considerations for the month of expiration

The argument for distant expirations

  • Distant expirations give you more time to get the stock direction and degree of move correct– but at the expense of increasing the extrinsic value of the option contract.  
  • Distant expirations carry more premium for option sellers to compensate for an increase extraneous risks such as war and politics
The argument for closer expirations
 
  •  More frequent trading
  • Less extrinsic value in the option and therefore a faster runway to profit
  • Option sellers benefit from an increase in the theta of the stock option.  The value of the option ( remember you keep the premium ) decreases faster. 
What I like
 
  • I like 30-45 DTE for the most part
  • I like same or next week expirations if I am sure of a direction and strength for quick hits.  Keep the contract numbers small and spread with narrow ( narrow widths are easier to roll to another expiration if you get the trade wrong )
 

Determine the width of the strikes

The argument for shorter strike widths

  • Shorter widths are easier adjust if the trade goes wrong
  • Shorter widths have less extrinsic value and therefore become more profitable faster
The argument for wider strike widths
 
  •  Wider widths collect more premium.  
  • Recall that the profit from any credit spread is equal to the premium collected
What I like for Credit Spreads
 
  • I like strike widths of about 3 -5 dollars that yield about 1 dollar or more in premium
  • I like strike widths up to about 10 dollars if I am pretty sure about the direction and strength of the move.
 

Move overall strategy and mindset

  • Most of the time, I like selling premium strategies
  • Instead of setting up iron condors or butterflies, I like legging into trades
  • I like buying 2 contracts at a time depending my confidence on the trade.  I even leg into contracts
  • I like credit spreads about 3-5 dollars wide as they are a lot easier to adjust and roll
  • I like credit spreads about 10 dollars wide ( only in a further out expiration ) if I am very sure of the direction and strength of the move – as I am more comfortable with the increased risk and potential hassle of adjusting the trade.  
  • I like expirations that are 30-45 days out as it gives the stock a chance to get its head right
  • I like 7-14 day out expirations for quick hits.  
  • I like buying or selling ITM or ATM options if I am confident of strength and direction.  The premiums are higher and they carry less extrinsic value.  
  • I will close the contract with the goal of making 50% of the premium noting that I will close earlier if the trade is looking shaky.  Or will close for more profit if there is still a lot of time left on a contract and  the stock is moving steadily in my favor.
  • I will close the contract early if the trade is looking shaky as it is better to have a small profit than a big ( or any ) loss.  Take the proceeds and place a different bet.  

Keys to understanding options

Indicators

Building Blocks

Greeks

Implied Volatility

The Mark

Trade Management