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.

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