Double diagonal spread as an income strategy | Live Nifty Example | Management | Recommendations

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In this video we will learn how to use the double diagonal spread as an income strategy.

What is a Double Diagonal Spread?

The double diagonal spread is a combination of a diagonal bull call spread and a diagonal bear put spread.

A diagonal bear put spread is achieved by selling an out of the money put while also buying a further out of the money put. The options have different expiration dates.

A diagonal bull call spread is achieved by selling an out of the money call while also buying a further out of the money call. Here too the options have different expiration dates.

The sold options are shorter term options and the bought options are longer term options.

How is a Double Diagonal Spread constructed?

A double diagonal spread combines the aforementioned strategies. It is the purchase of an OTM put at strike price X1, the sale of an OTM put at strike price X2, the sale of an OTM call at strike price X3, and the purchase of an OTM Call at strike price X4.

The price of the underlying should be between X2 and X3. You are expected to continue selling shorter term options as long as the price of the underlying stays between X2 and X3.

The double diagonal spread strategy is deployed only if a trader is expecting little to no movement in the underlying asset price over the life of the longer term options.

The effect of Greeks:

As shorter term options decay at a faster rate than longer term options, time decay (Theta) is helpful to the position. That is, by entering this market neutral strategy the trader seeks to take advantage of the difference in the rate of time decay between a shorter term option and a longer term option.

Though the Double Diagonal has a similar risk/reward profile of an Iron Condor, Double Diagonal is a positive Vega strategy and Iron Condor on the other hand is a negative Vega strategy. That is, an increase in volatility would help the double diagonal position.

Let us look at a sample trade:

Nifty is at 10000 on June 4, 2020. A Double Diagonal Spread position can then be entered as follows:

Buy one 30 July 9000 strike price Put at 112.45 (X1)
Sell one 11 June 9400 strike price Put at 19.05 (X2)
Sell one 11 June 10600 strike price Call at 15.05 (X3)
Buy one 30 July 11000 strike price Call at 75.75 (X4)

Risk graph:

It is clear from the risk graph that the trader would make a profit as long as the underlying stays between the sold options. And the maximum profit at expiry is attained when the underlying ends exactly at the strike price of one of the sold options.

The exact profit and loss calculations cannot be made for this strategy as we are dealing with options with different expirations.

Income Strategy:

Traders often look at the Double Diagonal as an income strategy, That is, they purchase longer term OTM calls and puts (about 2-12 months to expiry) and sell shorter term weekly options. The strategy can also be seen as buying one longer term straddle and selling one shorter-term strangle. If the trader is looking to sell weekly strangles he/she would roll out the strangle each week.

Say, by 18th June, if Nifty is still between X2 and X3, you would buy to close the 11 June 9400 strike price Put and 10600 strike price Call and sell to open the 18th June 9400 strike price Put and 10600 strike price Call there by collecting more premium.

This you would repeat until the end of July. In the last week of July, assuming you are in the trade till then, the setup would be nothing but a weekly Iron Condor.

Recommendations:

We recommend using the double diagonal spread strategy on index options as they are less volatile than individual stock options.

Also index options are more liquid. Meaning you can be more certain of exiting a trade at your desired price.

As mentioned earlier, consider buying options that are two-three months or more in duration and selling weekly options, as the difference in the rate of time decay between a shorter term option and a longer term option would help the position.

Management:

Look to roll out the short option to the next week whenever you see it getting close to being in the money.

Another way to manage the double diagonal is to add another OTM diagonal spread to the tested side. That is, if the call side is tested add another diagonal bull call spread five to six strikes above the existing spread.

Likewise, if the put side is tested add another bear put spread five to six strike below the existing spread. This adjustment would push the break even point farther away.