Conquer Range-Bound Stocks with Options

05/17/2012 7:00 am EST

Focus: OPTIONS

Josip Causic

Instructor, Online Trading Academy

The double-diagonal option strategy, a close relative of the iron condor, can be used to generate long-term profits from prolonged periods of range-bound trading, explains Josip Causic.

In this MoneyShow.com article, I will go over the basics of a double-diagonal option trade with an example. The double-diagonal option strategy aims to make money on a stock that is trading within a range and is not expected to move heartily in either direction.

Prior to the discussion of the specifics, let me define a double diagonal. In layman’s terms, the double diagonal is a close relative of an iron condor with the main difference being the expiration months for the short legs not being in the same month as the long legs.

See also: Iron Condor: Profit Big on Small Moves

Here are the differences between an iron condor and a double-diagonal option trade:

Iron Condor

  • Long and short calls in the same month
  • Long and short puts in the same month

Double Diagonal

  • Short calls and short puts in the front month
  • Long calls and long puts in the back month

Either strategy is a Delta-neutral position, meaning we have the expectation that the underlying stock will stay range bound.

The main difference between the two is that the iron condor, which is basically composed of two vertical credit spreads, ideally should be done when the implied volatility (IV) is high. Meanwhile, the double diagonal should ideally be placed when the IV is very low.

Strike selections for both the long iron condor legs as well as the double-diagonal legs are out of the money (OTM). In the double-diagonal trade, the sold premium brings in profit from the Theta (or time decay).

See also: Understanding Theta and Time Decay

These hypothetical examples below split the double diagonal into two parts, the bearish side and the bullish side.

XYZ Stock at $15.50: Double Diagonal, Bullish Side

  • Target: To close above the sold 14 put, (currently $1.50 protection)
  • Break Even Point (BEP): $14 - $.05 = $13.95
  • Sell to Open (STO) – 1 Jan [2011] (2x OTM) 14 puts @ $0.05 (money in)
  • Buy to Open (BTO) + 1 Jan [2013] (3x OTM) 13 puts @ $1.55 (money out)
  • Max Loss (debit): $1.50
  • Stop Level: At or below $14. If hit, then buy to close (BTC) the short 14 put

In order to simplify things, I have presented each side the exact way that I record it on my 3 x 5 trading index card. The very first line spells out the ticker and the underlying price at entry, the option strategy, and the outlook for the trade.

The next line names the target and the very last one names the stop. Going back to the target, we have selected a realistic goal of XYZ closing above the sold 14 put, while at the time of entry, the instrument was sitting at $15.50, which is a cushion of $1.50. Due to such big protection, the premium for selling that leg was only a nickel. All that we were expecting is that the XYZ stays above the sold 14 put.

For the stop, we have selected a conditional order stating the following: If XYZ is at or below $14, then BTC (buy to close at the market) the obligation; namely, the short 14 put.

Here is the bearish side of the trade:

XYZ Stock at $15.50: Double Diagonal, Bearish Side

  • Target: To close below the sold 16 call (currently $0.50 protection)
  • Break Even Point (BEP): $16 + $0.18 = $16.18
  • BTO + 1 Jan [2013] (3x OTM) 17 call @ $1.78 (money out)
  • STO – 1 Jan [2011] (2x OTM) 16 call @ $0.18 (money in)
  • Max Loss (debit): $1.60
  • Stop Level: At or above $16. If hit, then buy to close the short 16 call

The specifics of the bearish side are very similar to the bullish side. The only difference is the forecasted expectation of XYZ closing below the sold 16 call, which at the time of entry was 50 cents away. However, just in case XYZ rips above the $16 zone, we would need to close our obligation, also with a conditional order. The specifics of the conditional stop were: If XYZ is at or above $16, then buy to close the short 16 call at the market.

Total possible max loss: Bearish side debit ($1.60) + bullish side debit ($1.50) = $3.10

This last analysis points out the total cost of the trade being only $310, or $3.10 per share. Once the Jan 2011 expiry passes, then the selling of the Feb 2011 contracts can be done, and so on and so forth.

As long as XYZ stays range bound month to month, then eventually, the debit of $3.10 will get paid off by selling the front month and the trader will end up with basically a free long trade that does not expire for many months (until January 2013).

By Josip Causic, instructor, Online Trading Academy

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