Papale on Calendars and Diagonals

By Steve Papale

I’m not what you would call a prepper.  I don’t have a bunker or a year’s supply of freeze dried food or stockpiles of ammo.  But it has been a strange year.  Flattish low vol markets the first half of the year followed by crazy moves in the last couple months.  Blood moons.  My son finally learned to parallel park (kind of).  But here’s what really got my attention:  the Cubs advanced in the playoffs.  They have a game tomorrow against St. Louis.  I’m starting to look at bunkers this weekend.

With markets in a what I would call a higher state of movement over the last couple months, some traders are looking for trades that are long vega.  In this way any move up in implied volatility can benefit the options position.  One such trade is the calendar.  The way we here at DiscoverOptions play this strategy is always from the long side, that is long the far month and short the closer in month.  The trade will always be a debit assuming you are using the same strike across both months.  There are several ways the calendar can be used depending on factors such as price target, capital or implied volatility expectation.

For example, if I am bearish I might place a calendar well below the current market level.  As markets sell off we begin to move into the profit zone of the spread.  Remember for calendars the point of maximum profit is the short strike.  And of course our maximum loss is whatever the debit is.   In addition, as we move down implied volatility is likely rising, benefiting our position, which is long vega.  By placing the calendar out of the money, the cost to place the trade is less than one that is at the money or already well within the profit zone.  Some traders instead of being long and short the same strike, may adjust the strikes, creating a diagonal spread.

A diagonal is basically a combined horizontal and vertical spread.  For example, I could be short an Oct 100 call and long a Nov 105 call.  Combined with the horizontal component I have an embedded short 100/105 call vertical.  This might make sense for a trader who has a bearish bias but like the calendar around those strikes.  In addition the debit of the spread will be less than the straight calendar because the November 105 call is cheaper than the 100 call.  But in economics and trading there is no free lunch.  Since you have an embedded short vertical there will be a margin requirement on the trade.

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