Diagonal Spread With Calls
The next strategy that we will study is called “Diagonal Spread.” It can be either created by Call options or Put options.
First, let us understand with calls:
You can think of this as a two-step strategy. It’s a cross between a long calendar spread with calls and a short call spread. It is a time decay play. Ideally, you will be able to establish this strategy for a net credit or for a small net debit.
I’m using the example of one-month diagonal spread. But please note, it is possible to use different time intervals. If you’re going to use more than a one-month interval between the near-month and far-month options, you need to understand the ins and outs of rolling an option position.
This spread involves selling an OTM call (say at strike 17500 when Nifty is trading at 17300) for the near month expiry (e.g. January) and buying a further OTM call (say for strike 17700) of the next month expiry (say February). At expiration of the January call, one shall again sell another call for strike 17500 but now for February expiry.
This strategy is to be executed when you are expecting neutral activity in the near term expiry month, and neutral to bearish activity during the next month.
Maximum profit is limited to the net premium received for selling both calls of strike 17500, minus the premium paid for the call of strike 17700. For step one, you want the Nifty to stay at or around 17500 until January expiry. For step two, you’ll want the Nifty to be below 17500 during February expiry.
Because there are two expiration dates for the options in a diagonal spread, a pricing model must be used to guess and estimate what the value of the far-month call will be when the near-month call expires.
The risk in this strategy is the difference between both the strikes, that is 200 – difference between 17700 & 17500 (of course we have to adjust the net premium inflow/outflow accordingly).
For this strategy, before January expiration, time decay is your friend, since the shorter-term call will lose time value faster than the longer-term call. After closing the January call with strike 17500 and selling another call of the same strike but February expiry, time decay is somewhat neutral. That’s because you’ll see erosion in the value of both the option you sold (good) and the option you bought (bad).
After the strategy is established, although you want neutral movement on Nifty if it’s at or below 17500, you’re better off if IV increases close to near-month expiration. That way, you will receive a higher premium for selling another call at 17500.
After January expiration, you have legged into a short call spread. If the forecast you made was correct and Nifty is approaching or below 17500, you want IV to decrease. That’s because it will decrease the value of both the options. Preferably you want them to expire worthless.
But if your forecast was incorrect and Nifty is approaching or above 17700, you want IV to increase. Firstly because it will increase the value of the option you bought faster than the option you sold, thereby decreasing the overall value of the spread. Secondly because it shows a higher probability of a price swing (hopefully a decline).
Ideally, you want some initial volatility with some predictability. Some volatility is good, because the plan is to sell two options, and you want to get as much as possible for them. On the other hand, we want the stock price to remain stable. That’s a bit of a paradox, and that’s why this strategy is for more advanced traders.
To run this strategy, you need to know how to manage the risk of early assignment on your short options.