The Ultimate Guide to Double Diagonal Trading
If you are looking for a solid and reliable way to skim the markets and make significant returns, then the double diagonal strategy is one of the best approaches. It is not your average trading strategy and has in most cases been deferred to highly experienced traders.
Though at the onset the double diagonal strategy might seem exceptionally complex, but once you figure it out, you will be able to generate quick and secure gains. If you need to review the basics then please check out my beginners guide to trading options!
What is the Double Diagonal Trading Strategy?
The double diagonal spread goes beyond the simple diagonal spread that uses either puts or calls. It is a combination of a bull call and bear put spread that aims to turn a profit from the least possible volatility in an underpinning security, at least initially. When the initial options reach expiry, the strategy offers a number of additional ways to make a profit.
Other characteristics of the strategy include the fact that each of the puts and calls uses the same expiry dates and that the long options here are more out of the money than the short ones.
The main goal of this trading strategy is to make gains from a neutral action on stock prices on short calls that have minimal risk. Double diagonals can either be debit spreads or credit spreads. The process will depend on relative options’ pricing as well as volatility. Good examples of debit spreads are bull call and bear put spreads. Credit spreads on the other hand could be bull put or bear call spreads.
For instance, if a stock is trading at $70 and a trader expects it to move $10 higher, they would buy a $70 call and sell an $80 call (debit spread). But if the trader was unsure whether it would move higher but felt it would remain above a support of $60, they could sell a $60 put and buy a $50 put (credit spread)
Double Diagonal vs Iron Condor
Double diagonal spreads are comparable to iron condors, the major difference being that long options expire after short options. Though this might sound complicated, it becomes much easier to understand if you think of it as combining the two simpler strategies of buying one iron condor and two calendar spreads.
The main advantage of using this method is that the output is the same as that of someone who trades two calendars and an iron condor, but at a lower price and with greater ease.
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A Step-by-Step Guide to Trading Double Diagonals
The double diagonal spread is four-legged, with the trader selling near month out-of-the-money options on both the call and put sides, and purchasing future-dated, further out-of-the-money options on both sides as well. The short call strike should always be higher than the short pull strike. The time span will depend on the trader’s confidence about the underlying closing by the first expiry date between the strikes.
Let us break down this trading process into simple steps that will make it easier to grasp the ins and outs of trading double diagonals.
Step 1: Setting up the optimal double diagonal pattern
At the start of this strategy, you would be running both a diagonal call and diagonal put spread, hence the name double diagonal. Both of these strategies are time-decay moves. This means that you will be making the most of the fact that the front month options time value decays at a faster rate than back month options.
The most ideal entry point has the underlying somewhere between the two sell strikes. Some more experienced traders choose to trade the strategy with a bearish or bullish bias. But most consider delta neutral or something close to it to be the optimal position.
Delta is a risk measure that assesses the degree to which a trading option is exposed to price shifts on the underlying asset, with values ranging between 1.0 and -1.0. A delta neutral strategy seeks to offset the negative and positive deltas for an overall delta of zero. It basically balances the responses to market movements within a specific range so as to result in a net change of zero for the position. This strategy means you do not have to forecast the market direction and makes it applicable on any market so long as there are options available and the market is moving.
Step 2: Trading for maximum potential profit
In most standard trading strategies, there is usually a defined maximum profit. But in the case of the double diagonal, it is not an exact science. The reason for this is that the trade involves options with two different months of expiry. The ideal situation would be to have your underlying remain between the sold strikes. This is because the profit potential is highest at this midpoint assuming all factors remain constant.
When entering a trade, it would be best to sell both the call and put option strikes in the front month and buy a call between one and two months out from the short call and up one strike and a put in the same period but down one strike.
In case the profit and loss chart happens to sag in the middle, then you need to bring both the short and long calls on strike 1. Trades that have a negative skew of more than 2 are a no-no, and those with a positive skew of more than 4 require further investigation.
The volatility skew refers to the difference in implied volatility between options in-the-money, at-the-money and out-of-the-money. Positive skews are also referred to as forward skews or volatility smiles because of their characteristic shape. They are common in forex market options and near-term equity options. They essentially imply a higher demand for options that are out-of-the-money or in-the-money. Negative skews, also known as reverse skews or volatility smirks are more common and are typical of index options or long-term equity options. They imply that in-the-money calls and out-of-the-money puts are more costly than out-of-the-money calls and in-the-money puts.
Step 3: Managing your trade
It might seem challenging to manage this strategy but with a few rules in place, it is a lot easier than it looks. It is important to enter a double diagonal with a range of 30 to 60 days to the expiry date for short options.
Set the profit target at between 15% and 20% and a stop loss at -25%. In the first ten days of having the trade on, if the underlying is leaning towards one of the short options, you need to either take the position off or look for ways to adjust. The same concept applies if the underlying hits one of the short positions.
Consider using index options as opposed to stocks or ETFs so as to avoid an early assignment risk. And more than all else, avoid having a saggy middle. You can do this by bringing all options closer to the money.
As with any other trading strategy, always take time to paper trade double diagonals before you actually start trading.
Summary of the double diagonal steps:
- Make sure to buy an out-of-the-money put (strike price A – around 60 days from expiration — back-month).
- Make sure to sell an out-of-the-money put (strike price B – around 30 days from expiration — front-month).
- Make sure to sell an out-of-the-money call (strike price C – around 30 days from expiration — front-month)
- Make sure to buy an out-of-the-money call (strike price D – around 60 days from expiration — back-month)
Optimal Market Conditions for Double Diagonal Trading
The double diagonal spread is the most appropriate strategy when forecasts suggest price action between the strike price of a short strangle. This is because the approach makes a profit from the expiry of time in the short strangle.
But the main advantage over the short strangle is that this spread has a minimal risk if stock prices either fall or rise sharply beyond the level of the strike price for the short strangle. However, the strategy calls for patience since the profit comes from time decay.
This strategy is very sensitive to volatility and it is important to have a measure of stability in the process of using this method. This means that the best time to enter the double diagonal spread is when you expect the least movement, if any, in the underlying, for at least a month.
The best instruments to trade with the double diagonal include:
- Stocks worth more than $30
- Stocks whose implied volatility is in the lowest third on a two-year range
- Stocks with sideways movements to ensure low volatility
- Stocks whose skews are in line and with less than four point points between them
- Predictable industries with an established pattern as opposed to startups
Double diagonal trading is an excellent long-term investment approach that allows for income trading and can be sure to make gains with the passing of time if used appropriately. The best time to run it is when you are expecting the least possible movement on stocks with regard to a minimum of two options’ expiration cycle. It offers the highest profit potential and lowest possible risk when the underlying remains between the two strikes without leaning too much to any one side.
Time decay will be your closest friend when executing the double diagonal strategy and the ideal situation is when all options expire worthless. It is most commonly used by pro traders, but anyone with a keen trading eye, a thorough grasp of implied volatility and an understanding on how to manage the options position will have a good run with it.
I hope you enjoy the article and that it helped advance your trading skills.