Diagonals: A Cheap Way to Get Long IV Without Using Much Capital
Diagonals: A Cheap Way to Get Long IV Without Using Much Capital
Diagonals are a unique trade for unique market environments
- Diagonals combine positive theta and bullish IV exposure that could work well in low IV markets.
- Diagonals are cheap and generally slower trades but can protect a portfolio from sharp moves in IV that would otherwise hurt a short premium trade like a strangle.
- Diagonals can be set up many ways, so the best way to learn is to trade and find what works well for you.
When implied volatility (IV) dries up, it is common to ask the question: "What do I do now as a premium seller?"
One of the key aspects of being a premium seller is that you generate positive theta in your portfolio. This means that every day that the market moves less than expected, you get paid. Theta refers to the rate of decline in the value of an option over time.
The problem is that when implied volatility drops below historical averages (currently, VIX is trading below 15) it becomes harder to sell premium and generate theta in our portfolios.
For premium sellers, we are left with a question, do we continue to sell into low implied volatility, or do we start buying premium and start paying theta in hopes of a big market move? How about neither?
A diagonal spread combines the positive theta component that premium sellers are used to while also having the potential to profit if implied volatility rises. It is the best of both worlds of having positive theta decay and while not being exposed to IV risk (which happens with short premium trades when IV drops to lows).
How do we construct this trade?
A diagonal spread is executed like a vertical call or put spread, but the long option is in a further expiration cycle than the short option. Since nearer expiration cycles carry higher theta values than the same option in longer expiration cycles, the net theta effect for this trade can be positive.
Additionally, since longer-dated options have greater exposure to equal changes in IV than shorter-dated options, a rise in implied volatility will also cause this trade to profit. The directional exposure of this trade will depend on whether you are using the calls or the puts, but you can construct a diagonal with a bullish, bearish, or even neutral bias (by placing the strikes close to each other).
The general rule of thumb for diagonals is the long option has roughly twice the duration as the short option. So, if you were selling a 30 days-to-expiration (DTE) put, you would buy a 60-DTE put as part of your diagonal. But of course, this is a guideline and not a set-in-stone principle. We aways suggest the trader plays around to find his/her ideal strategy.
What is the ideal result?
Ideally, when you trade diagonals, you want the stock to move in the direction that would favor the long option, along with seeing volatility rise.
When trading equities, the most likely way to see both of those at the same time is going long a put diagonal. Remember, when stock markets drop, IV tends to rise at the same time. The difference between this trade and a vertical spread where both options are at the same expiration is the sensitivity to the speed of the market move.
If you think the market will make a fast move, you may just want to stick with a vertical spread with the same DTE on both options. If you think the market will have a slower move coupled with rising IV, a diagonal will be better. At the end of the day, there is no right or wrong, but this strategy can be played with so that when IV dries up, you will not feel forced to choose between only negative theta or selling cheap premium. The diagonal spread provides a unique twist to your portfolio.
Watch this segment of the tastylive team breaking down diagonals in greater detail.
For live daily programming, market news and commentary, visit tastylive or the YouTube channels tastylive (for options traders), and tastyliveTrending for stocks, futures, forex & macro.
Trade with a better broker, open a tastytrade account today. tastylive, Inc. and tastytrade, Inc. are separate but affiliated companies.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastylive content is created, produced, and provided solely by tastylive, Inc. (“tastylive”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, digital asset, other product, transaction, or investment strategy is suitable for any person. Trading securities, futures products, and digital assets involve risk and may result in a loss greater than the original amount invested. tastylive, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastylive is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparisons, statistics, or other technical data, if applicable, will be supplied upon request. tastylive is not a licensed financial adviser, registered investment adviser, or a registered broker-dealer. Options, futures, and futures options are not suitable for all investors. Prior to trading securities, options, futures, or futures options, please read the applicable risk disclosures, including, but not limited to, the Characteristics and Risks of Standardized Options Disclosure and the Futures and Exchange-Traded Options Risk Disclosure found on tastytrade.com/disclosures.
tastytrade, Inc. ("tastytrade”) is a registered broker-dealer and member of FINRA, NFA, and SIPC. tastytrade was previously known as tastyworks, Inc. (“tastyworks”). tastytrade offers self-directed brokerage accounts to its customers. tastytrade does not give financial or trading advice, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastytrade’s systems, services or products. tastytrade is a wholly-owned subsidiary of tastylive, Inc.
tastytrade has entered into a Marketing Agreement with tastylive (“Marketing Agent”) whereby tastytrade pays compensation to Marketing Agent to recommend tastytrade’s brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastytrade. tastytrade and Marketing Agent are separate entities with their own products and services. tastylive is the parent company of tastytrade.
tastycrypto is provided solely by tasty Software Solutions, LLC. tasty Software Solutions, LLC is a separate but affiliate company of tastylive, Inc. Neither tastylive nor any of its affiliates are responsible for the products or services provided by tasty Software Solutions, LLC. Cryptocurrency trading is not suitable for all investors due to the number of risks involved. The value of any cryptocurrency, including digital assets pegged to fiat currency, commodities, or any other asset, may go to zero.
© copyright 2013 - 2024 tastylive, Inc. All Rights Reserved. Applicable portions of the Terms of Use on tastylive.com apply. Reproduction, adaptation, distribution, public display, exhibition for profit, or storage in any electronic storage media in whole or in part is prohibited under penalty of law, provided that you may download tastylive’s podcasts as necessary to view for personal use. tastylive was previously known as tastytrade, Inc. tastylive is a trademark/servicemark owned by tastylive, Inc.