We like to sell options using high implied volatility strategies, but implied volatility (IV) is currently low for most underlyings. So, there are few high implied volatility rank (IVR) opportunities. We decided to compare two different defined risk directional strategies: Vertical Spreads and Diagonal Spreads. These strategies are ideal for low IV environments.
A vertical spread is made up of a long and short call or put at different strikes in the same expiration cycle. A diagonal debit spread is made up of a long and short call or put at different strikes in different expiration cycles.
We like to structure debit diagonal spreads by purchasing a longer-term in-the-money (ITM) option while selling a near-term out-of-the-money (OTM) option. The debit we are willing to pay must be less than the width of the strikes. We like to structure debit vertical spreads so the long strike is ITM, the short strike is OTM and the intrinsic value of our long strike is greater than what we paid for the spread. This results in positive theta (time decay).
When comparing theoretical risk exposures, it is clear that a diagonal spread is much more exposed to changes in IV and also has positive time decay (theta) when constructed properly. The trade is slightly less directional because the delta of the long-term option is less sensitive to changes in the underlying. An example demonstrating this was shown using AAPL.
A diagonal debit spread can be used as a replacement for a covered call, which is sometimes referred to as a Poor Man’s Covered Call on our network. Diagonals also provide the opportunity to reduce cost basis.
For more on Diagonal Spreads you can check out our archives:
- tastyBites from August 27th, 2014 "Contrarian Diagonals"
- Options Jive from on March 29th, 2016 "How to Structure Diagonals"
- Market Measures from March 29th, 2016 "Bullish Diagonals: The Poor Man’s Covered Call"
Watch this segment of “Options Jive” with Tom Sosnoff and Tom Preston for the valuable takeaways and insight into when to use debit vertical spreads or debit diagonal spreads.
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