At the outset of this strategy, you’re simultaneously running a diagonal call spread and a diagonal put spread. Both of those strategies are time-decay plays. You’re taking advantage of the fact that the time value of the front-month options decay at a more accelerated rate than the back-month options
At first glance, this seems like an exceptionally complicated option strategy. But if you think of it as capitalizing on minimal stock movement over multiple option expiration cycles, it’s not terribly difficult to understand how it works.
Typically, the stock will be halfway between strike B and strike C when you establish the strategy. If the stock is not in the center at this point, the strategy will have a bullish or bearish bias. You want the stock to remain between strike B and strike C, so the options you’ve sold will expire worthless and you will capture the entire premium. The put you bought at strike A and the call you bought at strike D serve to reduce your risk over the course of the strategy in case the stock makes a larger-than-expected move in either direction.
You should try to establish this strategy for a net credit. But you may not be able to do so because the front-month options you’re selling have less time value than the back-month options you’re buying. So you might choose to run it for a small net debit and make up the cost when you sell the second set of options after front-month expiration.
As expiration of the front-month options approaches, hopefully the stock will be somewhere between strike B and strike C. To complete this strategy, you’ll need to buy to close the front-month options and sell another put at strike B and another call at strike C. These options will have the same expiration as the ones at strike A and strike D. This is known as “rolling” out in time. See rolling an option position for more on this concept.
Most traders buy to close the front-month options before they expire because they don’t want to carry extra risk over the weekend after expiration. This helps guard against unexpected price swings between the close of the market on the expiration date and the open on the following trading day.
Once you’ve sold the additional options at strike B and strike C and all the options have the same expiration date, you’ll discover you’ve gotten yourself into a good old iron condor. The goal at this point is still the same as at the outset—you want the stock price to remain between strike B and C. Ultimately, you want all of the options to expire out-of-the-money and worthless so you can pocket the total credit from running all segments of this strategy.
Some investors consider this to be a nice alternative to simply running a longer-term iron condor, because you can capture the premium for the short options at strike B and C twice.
Maximum Potential Profit
Potential profit for this strategy is limited to the net credit received for the sale of the front-month options at strike B and strike C, plus the net credit received for the sale of the second round of options at strike B and strike C, minus the net debit paid for the back-month options at strike A and strike D.NOTE: Because you don’t know exactly how much you’ll receive from the sale of the additional options at strikes B and C, you can only “guesstimate” your potential profit when establishing this strategy.
Maximum Potential Loss
If established for a net credit at initiation of the strategy, risk is limited to strike B minus strike A minus the net credit received. If you are able to sell an additional set of options at strikes B and C, deduct this additional premium from the total risk.
If established for a net debit at initiation of the strategy, risk is limited to strike B minus strike A plus the debit paid. If you are able to sell an additional set of options at strikes B and C, deduct this additional premium from the total risk.NOTE: You can’t precisely calculate your risk at initiation of this strategy, because it depends on the premium received (if any) for the sale of the additional options at strikes B and C.
Break-even at Expiration
It is possible to approximate your break-even points, but there are too many variables to give an exact formula.
Because there are multiple expiration dates for the options in this strategy, a pricing model must be used to “guesstimate” what the value of the back-month options will be when the front-month options expire. TradeKing’s Profit + Loss Calculator can help in this regard. But keep in mind, the Profit + Loss Calculator assumes that all other variables such as implied volatility, interest rates, etc. remain constant over the life of the trade, and they may not behave that way in reality.
TradeKing Margin Requirements
Margin requirement is the diagonal call spread requirement or the diagonal put spread requirement (whichever is greater).
NOTE: If established for a net credit, the proceeds may be applied to the initial margin requirement.
Keep in mind this requirement is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.
As Time Goes By
For this strategy, time decay is your friend. Ideally, you want all of the options to expire worthless.
After the strategy is established, although you don’t want the stock price to move much, it’s desirable for volatility to increase around the time the front-month options expire. That way, you will receive more premium for the sale of the additional options at strike B and strike C.
After front-month expiration, the effect of implied volatility depends on where the stock is relative to your strike prices.
If the stock is near or between strikes B and C, you want volatility to decrease. This will decrease the value of all of the options, and ideally, you’d like everything to expire worthless. In addition, you want the stock price to remain stable, and a decrease in implied volatility suggests that may be the case.
If the stock price is approaching or outside strike A or D, in general you want volatility to increase. An increase in volatility will increase the value of the option you own at the near-the-money strike, while having less effect on the short options at strikes B and C.