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Generate Income Trade Options
Let’s recall the definition of spreads, and what metrics each type of spread relates to
Strike Price relates to Delta, and contract term (expiry month) relates to Theta
It is wise to know that when someone comes up with an option trading idea, they usually work it on paper and by doing rough calculations in their mind. The idea is usually interesting, but most seasoned traders never actually, exactly copy no one else’s idea! Rather they take it, they modify it, and then they use it in their own unique way.
We have seen in the case of Ratio Spreads, that most theories about them present this spread as being vertical, (all options have one month until expiration). This is just mentioned like that for the sake of simplicity, and not confusing the reader away from the main objective. Once the main objective has been understood, it doesn’t take a rocket scientist to figure out, that some improvements can be made immediately. By devising a Diagonal Ratio Spread instead. You just have to recall early advice that says; always buy options with more than 30 days to expiry, actually this means: options that will have at least 30 days to expiry throughout the Spread’s life!
Diagonal Option Spread example
Buy 1 ABC Sep 80 Call at $400
Short 1 ABC Oct 90 Call at $200
This is referred to as a Debit Diagonal Spread because if the options expired at current stock price, the net premium the trader pays is $200, if the net premium is negative, this means the trader actually receives money, (credit received exceeds premium paid) and it would be called a Credit Diagonal Spread.
One simple Diagonal Spread can be used to improve the Horizontal Calendar Spreads concept. In this case the objective is to profit from time decay while offsetting market risk, by writing one soon expiring option, and being long another option with longer contract term (more time to expire).But why stay horizontal? Do both options really need to have the same strike price?
Remember that option trading is all about paying attention to detail, and exploiting overlooked opportunities. While it is essential for option trading educators to keep it simple, you also have to take it further, look beyond the oversimplified, educational option trading examples!
In the case of Horizontal Calendar Spreads, you can instead use a Diagonal Calendar Spread, where you do sell a soon expiring option with around 25-30 days to go, and you also buy another option of the same type but with a further out expiry date. But, you pick different strike prices, so that you overall allow for the stock to move in a neutral price zone area.
For instance, a stock trading at $50, that has a technical reason (ADX reading below 20) to stay trend-less, may provide a good opportunity to implement such a strategy upon.
Things can go a long way with options, there are traders who implement all known trading strategies, but also combine them with continuous contract renewal.
If this $50 stock is expected to trade within a tight range of $48-$52 for a long time, it shows a strong support at $48, and a less strong resistance at $52, nonetheless the trader believes that there will be at least 10 price swings within that price channel, and that it will take around 60 to 90 days till a breakout occurs. So the trader makes a Diagonal Calendar Spread, writing a soon expiring Call with a 52 strike price, and buying a further out Call with any strike price that would make it to be ATM. Ideally the trader wants to take advantage of the very stock price, on that day! If the stock has risen $2 on that day, (and that is $2 relative to the middle of the trading range, between 48 and 50) the expectation is that it will soon revert back to the middle of the trading range (50), or maybe lower. So in this case he would write the safest, most expensive (ATM to ITM) Call he could, and he would buy a cheaper OTM Call, few strike prices lower just to protect in case of a severe, unexpected breakout (and also limit broker margin requirements). When the stock drops back from $52 to $50 or $48, the trader can buy back his written Call at a much lower price making an instant profit while writing another Call at a new price. And he is able to profit from the time decay, all along!
Remember how Delta behaves when ITM and how when OTM, that’s what provides opportunity!
The trader can continuously throughout the 60-90 day period, renew his spread as follows, even though the objective is to always hold written options with around 25 days to expiration, the actual stock is expected to remain in this limbo mode for as long as 3 months! So the trader has to act accordingly, and sticking to a single strike price for all contracts used, is not a very efficient way to trade options on this stock.
Diagonal Calendar Spreads is a very versatile strategy, there are however some concerns that you should be aware of, such as implied volatility. A sudden collapse of implied volatility can case this strategy to fail, always make sure implied volatility of the soon expiring option is higher than the implied volatility of the further out option! Other than that, the strategy works great in environments of rising volatility as well as neutral volatility on the markets.
Analyzetrade.com offers the right tools to track both volatility metrics as well as actual stock price history, in a very accurate and professional way, losing trades can be identified in advance using Analyzetrade.com simulation tools, and you will be amazed at how minor details make all the difference! Analyzetrade.com helps expose seemingly good trades that would have lost you money, and equally it helps uncover hidden profitable trades, that very few traders suspect they exist!
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