This will be a short post which I will revisit and add more content if/when I have time. The topic is the short Diagonal which is a Credit spread. Being a Credit spread means that the short leg is closer to ATM (at-the-money) and the long leg is further OTM (out-of-the-money). Credit spreads have a margin requirement that is equal to the width of the spread. The potential maximum loss is equal to the margin requirement less the Credit received when initiating the position. Since the Credits received in this strategy are generally less than 10% of the margin requirement I just use the margin requirement as my potential loss.
Since the Credit received in this strategy is generally less than 10% of margin requirement (potential loss) where is the big payoff? I don’t want to risk $100 to just make $10 (or less), how about you? I believe I have an edge in my ability to use price action to develop a directional bias but, of course, that bias can and should change as the price action changes! If I’ve placed a trade for a Credit and price initially moves in the expected direction but then stalls out or even reverses, it’s very possible that the trade can expire virtually worthless which is fine since I received a Credit when I placed the trade. However, the big payoff happens if price is at or near the short strike in the spread at expiry! Below is a screenshot I took of various SPX option spreads at Friday’s (1/26) close. The $10-wide, ATM, short Call Diagonal with Jan26/29 expiry was worth $6.75. That’s a 67% return on maximum loss. But how much would the Credit have been when I could have initiated the trade? For that, I can use this coming week’s spread as a guide. Unfortunately, when I took the screenshot I had the Feb2/5 SPX 5000/5010 ($10-wide) Call Diagonal shown and that was a $.25 Debit (because it was so far OTM). In order to collect a Credit I would’ve probably needed to use the 4960/4970 strikes. Since the potential maximum risk on a short Call Diagonal is to the upside some traders may prefer to pay a small Debit to move it further OTM and to reduce the likelihood that a max loss occurs. Each trader should fit the risk profile to match their comfort level!
The best time to initiate the short Call Diagonal is not when price is at a bullish setup on the chart but rather when it’s already made a move higher just like the best time to initiate a short Put Diagonal is after price has moved lower and looks to be either reversing or consolidating! There are many weeks where I own both a short Put and short Call Diagonal. The risk profile looks just like a standard Double Diagonal but there is no potential for loss in the middle of the spread because it was initiated for a net Credit. The max loss (margin req) on a $10-wide short Call or Put Diagonal is $10 (x $100 for SPX) and the max loss on a $10-wide short Double Diagonal is also $10 because there can’t be a max loss on both spreads at expiry! No matter how much the VIX (SPX implied volatility) might collapse during the week the middle of the spread cannot move below the $0 profit line because, as shown in the risk profile below, both Diagonals were initiated for a Credit! If SPX is at the middle of the Double Diagonal at expiry I get to keep the 2 Credits that I received so this position should show at least a small profit and potentially a big profit if SPX is up or down less than about 2% next week.
The potential profit on a Double Diagonal can be even greater if I leg-into the position. Let’s assume SPX was moving lower early in the week and the 8-hour SMA bands started to turn up. I could add the Put Diagonal for a Credit and then, if SPX moved higher as expected but then the bands started to rollover that would be the time to add the Call Diagonal for a Credit. At that point I’d likely have a fairly wide Double Diagonal for a Credit with 2 large potential profit areas at the extreme ends of the price range. For those who are familiar with my chart analysis strategies of using prior and current week’s high, low, and HB (Half-Back or midpoint) or Fib resistance/support zones as likely pivot points you can get some idea of where I typically place the short strike on the Diagonals.
That’s all I have. Questions or comments down below on or Twitter (X) @VegaOptions.