Diagonal Spread: Low risk Options Strategy

Trading in options is considered as very risky especially for newbies. Options are known to wipe out entire trading capital of most of the retail traders. It’s indeed a dangerous game to play but if used cautiously with proper risk management it can do wonders for you. In this post, we are going to introduce a proven low risk options strategy known as Diagonal Spread. Trading naked options is very riskier and one should avoid it unless you are extremely sure about the future price movement. That is the reason experienced investors trade in Option spreads which involves both buying and selling of option strikes. For ex: Buy 8600 Nifty CE and Sell 8800 Nifty CE. In this scenario one position hedges the other thus limiting your risk.

Check out our other Options strategies in the below link:

Options Strategies Archive

Diagonal spread options strategy

Diagonal spread is a kind of options spread where far month option is bought and near month option is sold. For ex: Buy 8600 Nifty CE December contract and Sell 8800 Nifty CE November contract. This strategy would be called bullish diagonal spread. Buying and selling Puts will constitute bearish diagonal spread. The idea behind this strategy is that far month options contract will suffer less time decay as compared to near month options contract. So even if the trade goes against you the loss would be minimal. Even sideways trend would not cause any loss, thus making this a very low risk options strategy. We will explain this with an example in the following section.

Illustration

We’ll try to apply this strategy on NSE Nifty Nov Expiry. Let’s suppose we had bearish view on Nifty at the start of November series, and so we entered in a bearish diagonal spread. We bought 1 lot of 8800 PE Dec series and sold 1 lot of 8600 PE Nov series. Below is the trade setup with P/L each day.

Low Risk Options Startegy

The strategy has earned a decent 2% profit in 8 trading days. Profit/Loss has been calculated considering 1 lot (75 quantities) of Nifty, and approx 70000 Rupees of initial margin to take this trade. You would definitely have earned better if you would have gone naked in long Puts, but then your risk would have grown substantially higher and any sideways movement might have hurt your capital.

Now, if Nifty expires at 8000 in Nov series, then below is the theoretical value of your position at the end of series:

Low Risk Options Startegy 2

This strategy would have earned 30% in a span of one month if our prediction is accurate.

How to select Strike Prices?

There are n number of ways to select strike prices while trading options. But for this strategy, we would recommend percentage hedge method. Below are the steps to select strike prices based on this method:

  • For long option take strike from the next/far month. Select the strike that is at-the-money (ATM) or slightly out-of-the-money (OTM). NOTE: ATM or OTM is with respect to current month futures price and not the next month (even though the strikes are being selected from the next month).
  • For short option take strike from the current/near month that is two strikes OTM from the long strike selected. Long and short options two strikes apart is optimum for NF. One strike apart and the profit will start to dip after price crosses the short strike which can be a major problem in managing the trade. More than two strikes part means you will not be able to get the optimum hedge % required (see the next point about this).
  • Compute the hedge % using the formula below:
    Hedge % = (Price of short call / Price of the long call ) * 100
  • If the hedge % is above 30% this strike combination can be selected. If the hedge % is less than 30%, start the process again from #1 by going for more nearer ATM or ITM option for long and then repeat the steps and recompute the hedge %. Most of the time we end up with ITM long and OTM short which is usually the optimum combination unless one is initiating the trade close to expiry when the position has to be more ITM to provide enough protection.
  • Once you have a strike combination with hedge % greater than 30%, it can be used to enter the trade.

Strategy Summary

Parameter Value
Trade Setup
Buy ITM or ATM option and Short OTM option.
Direction Neutral?
No. Trade Call options if you have Bullish view and trade Put options if you have Bearish view.
Strike Price selection
Select the strike prices so that hedge % among both the strikes is greater than 30%.
When to enter? Trade should be entered usually 15-30 days before current month expiry. Avoid entering in the expiry week as the time decay may hurt you.
When to exit? Trade should be exited usually 2-3 days before expiry.
Stock Selection
Trade highly liquid option contracts as this strategy involves buying of far month contract.
Risk Management
Try to maintain a risk reward ratio of 2:1. Example: 20% target and 10% stop loss

Download Excel Sheet: Low risk Options Strategy

Please see the below link to download excel sheet for Diagonal Spread: Low risk options strategy. You may use this sheet to test the strategy result on variety of contracts. You would need to enter the prices manually and the profit/loss would be calculated automatically. Please let us know if you have any queries.

Diagonal Spread

4 Comments

  1. It’s very useful to newbies like me. Please let me know how to find out the market is bullish or bearish. Last month your prediction is exactly bearish like mentioned. Please let me know very simple indicator to find trend. Thanks in advance.

    • There are n number of ways to determine the market trend. Please go through other strategies posted in this website.

  2. Nifty 8800 PE on expiry with Nifty Spot 8000 is 1000 ?? plz correct it 800
    Max Profit here is Spread-Debit = 80 (around) points.

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