7/16/22, 11:49 AM What Is Double Diagonal Spread?

- Fidelity

Double diagonal spread

THE OPTIONS INSTITUTE AT CBOE®

Neutral

Potential goal
To profit from neutral stock price action between the strike prices of the short calls
with limited risk.

Explanation

Example of double diagonal spread

Sell 1 28-day XYZ 95 put at 1.30

Buy 1 56-day XYZ 100 put at (3.80)

Buy 1 56-day XYZ 100 call at (4.00)

Sell 1 28-day XYZ 105 call at 1.50

Net cost = (5.00)

A double diagonal spread is created by buying one “longer-term” straddle and

selling one “shorter-term” strangle. In the example above, a two-month (56 days to
expiration) 100 Straddle is purchased and a one-month (28 days to expiration) 95 –
105 Strangle is sold. This strategy is established for a net debit, and both the profit
potential and risk are limited. The maximum profit is realized if the stock price is
equal to the strike price of one of the short options on the expiration date of the
short-term options, and the maximum risk is realized if the stock price is equal to the
strike price of the straddle and if the straddle is held to its expiration.

This is an advanced strategy because the profit potential is small in dollar terms. As
a result, it is essential to open and close the position at “good prices.” It is also
important to trade a large quantity of spreads so that the per-contract commission is
as low as possible.

Maximum profit
The maximum profit is realized if the stock price is equal to the one of the strike
prices of the short strangle on the expiration date of the short strangle. With the
stock price at the strike price of the short call at expiration of the strangle, for
example, the profit equals the price of the long straddle minus the net cost of the
diagonal spread including commissions. This is a point of maximum profit because
the long call component of the long straddle has its maximum difference in price
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with the expiring short call. Similarly, the stock price at the strike price of the short
put at expiration of the strangle is a point of maximum profit because the long put
component of the long straddle has its maximum difference in price with the
expiring short put. It is impossible to know for sure what the maximum profit
potential is, because it depends of the price of the long straddle, and that price is
subject to the level of volatility which can change.

Maximum risk
The maximum risk of a double diagonal spread is equal to the net cost of the spread
including commissions. This amount is lost if the stock price is equal to the strike
price of the straddle and if the straddle is held to its expiration. In this case, the
value of the straddle declines to zero and the full amount paid for the spread is lost.

Breakeven stock price at expiration of the short call

There are two breakeven points, one above the strike price of the short call and one
below the strike price of the short put. Conceptually, a breakeven point at
expiration of the short strangle is the stock price at which the price of the long
straddle equals the net cost of the spread minus the expiration value of the strangle.
It is impossible to know for sure what the breakeven stock price will be, however,
because it depends of the price of the long straddle which depends on the level of
volatility.

Profit/Loss diagram and table: double diagonal spread

Sell 1 28-day XYZ 95 put at 1.30

Buy 1 56-day XYZ 100 put at (3.80)

Buy 1 56-day XYZ 100 call at (4.00)

Sell 1 28-day XYZ 105 call at 1.50

Net cost = (5.00)

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7/16/22, 11:49 AM What Is Double Diagonal Spread? - Fidelity

Stock Price at Short 1 28-day 95- Long 1 56-day 100 Net Profit / (Loss)
Expiration of the 105 Strangle Straddle at Expiration of
28-day Options Profit/(Loss) at Profit/(Loss) at the 28-day
Expiration Expiration of the Options
28-day Options*

120 (12.20) +12.15 (0.05)

115 (7.20) +7.65 +0.45

110 (2.20) +3.00 +0.80

105 +2.80 (1.85) +0.95

100 +2.80 (1.90) +0.90

95 +2.80 (1.95) +0.85

90 (2.20) +2.70 +0.50

85 (12.20) +12.15 (0.05)

*Profit or loss of the long straddle is based on its estimated value on the expiration
date of the short strangle. This value was calculated using a standard Black-Scholes
options pricing formula with the following assumptions: 28 days to expiration,
volatility of 30%, interest rate of 1% and no dividend.

Appropriate market forecast

A double diagonal spread realizes its maximum profit if the stock price equals one
of the strike prices of the short strangle on the expiration date of the short strangle.
The forecast, therefore, must be “neutral.”

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Typically, the stock price is at or near the strike price of the straddle when the
position is established, and the forecast is for neutral price action between the strike
prices of the short strangle.

Strategy discussion

A double diagonal spread is the strategy of choice when the forecast is for stock
price action between the strike prices of the short strangle, because the strategy
profits from time decay of the short strangle. Unlike a short strangle, however, a
double diagonal spread has limited risk if the stock price rises or fall sharply beyond
one of the strike prices of the short strangle. The tradeoff is that a double diagonal
spread is established for a net debit and has a much lower profit potential profit
than a short strangle. A double diagonal spread must also be closed at or prior to
the expiration date of the strangle and, therefore involves more bid-ask spreads and
commissions than a strangle.

Patience and trading discipline are required when trading double diagonal spreads.
Patience is required because this strategy profits from time decay, and stock price
action can be unsettling as it rises and falls around one of the strike prices of the
short strangle as expiration approaches. Trading discipline is required because the
profit potential of a double diagonal spread is “small” in dollar terms. Traders must,
therefore, enter limit-price orders when entering and exiting a double diagonal
spread position. Traders must also be disciplined in taking partial profits if possible
and in taking “small” losses before the losses become “big.”

Impact of stock price change

“Delta” estimates how much a position will change in price as the stock price
changes. Long calls and short puts have positive deltas, and long puts and short
calls have negative deltas. If the stock price is close to the strike price of the straddle
when a double diagonal spread is first established, the net delta is close to zero.
With changes in stock price and passing time, however, the net delta varies from
slightly positive to slightly negative, depending on the relationship of the stock price
to the strike prices of the short options and on the time to expiration of the short
strangle.

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If the stock price equals the strike price of the short call at expiration of the short
strangle, the position delta approaches +0.50. In this case, the delta of the in-the-
money long call is approximately +0.75 (depending on volatility and on the time to
expiration), and the delta of the out-of-the-money long put is approximately −0.25.

If the stock price equals the strike price of the short put at expiration of the short
strangle, the position delta approaches −0.50. In this case, the delta of the in-the-
money long put is approximately −0.50 (depending on volatility and on the time to
expiration), and the delta of the out-of-the-money long call is approximately +0.25.

If the stock price is above the strike price of the short call at expiration of the short
strangle, the position delta is negative, because the delta of the long call
approaches +0.90 and the delta of the in-the-money expiring short call approaches
−1.00. If the stock price is below the strike price of the short put at expiration of the
short strangle, the position delta is positive, because the delta of the long put
approaches −0.90 and the delta of the in-the-money expiring short put approaches
+1.00.

Impact of change in volatility

Double diagonal spreads are highly sensitive to volatility. It is therefore necessary to
forecast that volatility not fall when using this strategy.

Volatility is a measure of how much a stock price fluctuates in percentage terms,

and volatility is a factor in option prices. As volatility rises, option prices tend to rise
if other factors such as stock price and time to expiration remain constant. Long
options, therefore, rise in price and make money when volatility rises, and short
options rise in price and lose money when volatility rises. When volatility falls, the
opposite happens; long options lose money and short options make money. “Vega”
is a measure of how much changing volatility affects the net price of a position.

Since vegas decrease as expiration approaches, a double diagonal spread has a net
positive vega. Consequently, rising volatility helps the position and falling volatility
hurts. The vega is highest when the stock price is equal to the strike price of the
long straddle and is only slightly lower when the stock price is equal to the one of
the strike prices of the short strangle.

The net vega approaches zero if the stock price rises or falls sharply beyond one of
the strike prices of the short strangle. At that point, one long option and one short
option are both deep in the money, and the other options are far out of the money.
The vegas of the out-of-the-money options are close to zero, and the vegas of the
in-the-money options are approximately equal and opposite and, therefore,
offsetting. Consequently, the net vega of the entire double diagonal spread is zero.

Impact of time
The time value portion of an option’s total price decreases as expiration
approaches. This is known as time erosion. “Theta” is a measure of how much time
erosion affects the net price of a position. Long option positions have negative
theta, which means they lose money from time erosion, if other factors remain
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constant; and short options have positive theta, which means they make money
from time erosion.

A double diagonal spread has a net positive theta as long as the stock price is in a
range between the strike prices of the short strangle. This means that a double
diagonal spread profits from time decay.

If the stock price rises or falls beyond a breakeven point, then the theta approaches
zero. At such a stock price, however, a double diagonal spread has undoubtedly
reached the point of maximum risk.

Risk of early assignment

Stock options in the United States can be exercised on any business day, and
holders of short stock option positions have no control over when they will be
required to fulfill the obligation. Therefore, the risk of early assignment is a real risk
that must be considered when entering into positions involving short options.

While the long call and long put in a double diagonal spread have no risk of early
assignment, the short call and put do have such risk. Early assignment of stock
options is generally related to dividends. Short calls that are assigned early are
generally assigned on the day before the ex-dividend date, and short puts that are
assigned early are generally assigned on the ex-dividend date. In-the-money calls
and puts whose time value is less than the dividend have a high likelihood of being
assigned.

If the short call is assigned, then 100 shares of stock are sold short and the long call
remains open. If a short stock position is not wanted, it can be closed in one of two
ways. First, 100 shares can be purchased in the market place. Second, the short 100-
share position can be closed by exercising the long call. Remember, however, that
exercising a long call will forfeit the time value of that call. Therefore, it is generally
preferable to buy shares to close the short stock position and then sell the long call.
This two-part action recovers the time value of the long call. One caveat is
commissions. Buying shares to cover the short stock position and then selling the
long call is only advantageous if the commissions are less than the time value of the
long call.

If the short put is assigned, then 100 shares of stock are purchased and the long put
remains open. If a long stock position is not wanted, it can be closed in one of two
ways. First, 100 shares can be sold in the marketplace. Second, the long 100-share
position can be closed by exercising the long put. Remember, however, that
exercising a long put will forfeit the time value of that put. Therefore, it is generally
preferable to sell shares to close the long stock position and then sell the long put.
This two-part action recovers the time value of the long put. One caveat is
commissions. Selling shares to close the long stock position and then selling the
long put is only advantageous if the commissions are less than the time value of the
long put.

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Note, however, that whichever method is used, trading stock or exercising a long
option, the date of the stock purchase (or sale) will be one day later than the date of
the short sale (or purchase). This difference will result in additional fees, including
interest charges and commissions. Assignment of a short option might also trigger a
margin call if there is not sufficient account equity to support the stock position
created.

Potential position created at expiration of the short strangle

The position at expiration of the short strangle depends on the relationship of the
stock price to the strike prices of the short options. If the stock price is at or between
the strike prices of the short strangle, then the both short options expire worthless
and the long straddle remains open.

If the stock price is above the strike price of the short call, however, then the short
call is assigned. The result is a three-part position consisting of a long call, a long put
and short 100 shares of stock. If the stock price is above the strike price of the short
call immediately prior to its expiration, and if a position of short 100 shares is not
wanted, then the short call must be closed.

If the stock price is below the strike price of the short put, then the short put is
assigned. The result is a three-part position consisting of a long put, a long call and
long 100 shares of stock. If the stock price is below the strike price of the short put
immediately prior to its expiration, and if a position of long 100 shares is not
wanted, then the short put must be closed.

Other considerations
Double diagonal spreads can be described in two ways. First, as described here,
they are the combination of a longer-term straddle and a shorter-term strangle.
Second, they can also be described as the combination of a diagonal spread with
calls and a diagonal spread with puts in which the long call and long put have the
same strike price.

The term “diagonal” in the strategy name originated when options prices were
listed in newspapers in a tabular format. Strike prices were listed vertically in rows,
and expirations were listed horizontally in columns. Therefore a “diagonal spread”
involved options in different rows and different columns of the table; i.e., they had
different strike prices and different expiration dates.

Note: This is an advanced strategy because the profit potential is small in dollar
terms. As a result, it is essential to open and close the position at “good prices.” It is
also important to trade a large quantity of spreads so that the per-contract
commission is as low as possible. The commissions for four options, and potentially
more options if some are exercised or assigned, could have a significant effect on
the potential profit of this strategy.

Related Strategies
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7/16/22, 11:49 AM What Is Double Diagonal Spread? - Fidelity

Long straddle
A long – or purchased – straddle is a strategy that attempts to profit from a big stock price
change either up or down.

Short strangle
A short strangle consists of one short call with a higher strike price and one short put with a
lower strike.

Article copyright 2013 by Chicago Board Options Exchange, Inc (CBOE). Reprinted with permission from CBOE. The
statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the
accuracy or completeness of any statements or data.

Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry
additional risk. Before trading options, please read Characteristics and Risks of Standardized Options . Supporting
documentation for any claims, if applicable, will be furnished upon request.

Greeks are mathematical calculations used to determine the effect of various factors on options.
Charts, screenshots,
company stock symbols and examples contained in this module are for illustrative purposes only.

691059.3.1

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