Neutral Spreads Get Tasty: Diagonals and Iron Condors

Bread ’n’ butter. Meat ’n’ potatoes. Rice ’n’ beans. When you’re hungry, you may rely on combinations of staple foods to deliver satisfying deliciousness. There’re some slight variations on the basic recipe. But when you see them on a menu, you can usually be fairly certain you’ll get a reliable, hearty meal to keep body and soul humming.

Order the Trader’s Combo

Some traders rely on strategies that combine positive time decay (theta) and defined risk. Positive theta might be beneficial in that time is on your side, all else being equal, and defined risk might deliver the confidence that no matter what a stock, index, or market does, a trading loss won’t exceed a size you can know when you enter the trade.

One typical trader’s combo is the iron condor. (See Figure 1.) It has positive theta, defined risk, and limited deltas, as long as options are far enough out of the money (OTM). It’s a market-neutral strategy you can use when you expect a stock or index price to stay in a range—specifically, between the strike prices of a short call and short put of an iron condor.

Now, the credit you receive when you sell an iron condor can be higher when volatility (vol) is higher, all things being equal. And that credit is the max potential profit of the iron condor, which impacts how much positive theta it has. This can make the credit important. Yet, when VIX is under 20, and the implied vol of individual stocks is low, iron condors might not deliver the credits you hunger for. 

It’s kind of like seeing meat and potatoes on the menu, but in appetizer-sized portions that won’t fill you up. But never fear. When your meat-and-potatoes iron condor needs to be more filling in a low-vol market, you can stretch it out by tweaking the strategy in a way that still maintains positive time decay and defined risk. On to the next dish: double diagonals.

Double or Nothing

The double diagonal (Figure 2) is an iron condor stretched across two expirations. It’s short an OTM call and OTM put within the same expiration, and long a further OTM call and OTM put. 

The double diagonal takes those long OTM calls and puts to a further expiration. So, the double diagonal’s short call and put are in an expiration with fewer days to expiry (DTE), and its long call and put are in an expiration with more DTE. 

For example, with XYZ at $40 per share, an iron condor could be a long 37 put, a short 38 put, a short 42 call, and a long 43 call, with 30 DTE. A double diagonal would be short the 38 put and 42 call with 30 DTE, and long the 37 put and 43 call, with 60 DTE. Like the iron condor, the double diagonal is designed to profit if the stock price stays in a range between the strike prices of the short call and put, which in this example would be between $38 and $42. The double diagonal also has positive theta and defined risk. 

All things being equal, the positive theta of the short 38 put and 42 call with 30 DTE will be greater than the negative theta of the long 37 put and 43 call with 60 DTE. Here, theta grows as the option approaches expiration. Theta is also higher when the option is closer to the money. In this case, the 38 put and 42 call with 30 DTE have higher theta than the 37 put and 43 call with 60 DTE, and the short 38 put and 42 call give the double diagonal net positive theta. 

The double diagonal also has defined risk. No matter how high or low the stock price, the double diagonal’s max risk is the difference between the long and short strikes (either calls or puts), minus any credit received, or plus any debit paid, including transaction costs. If you created the double diagonal in XYZ for a $0.20 credit, the max risk would be $38 – $37 – $0.20, or $0.80, or $80 per double diagonal. If you paid a $0.30 debit for the double diagonal, the max risk would be $38 – $37 + $0.30 = $1.30, or $130 per double diagonal, plus transaction costs. Those max losses happen if the stock falls below the long put strike, or sits above the long call strike ($37 or $42 in this example) at the long options’ expiration. 

So, what does the double diagonal do that the iron condor doesn’t? By pushing the long options to a further expiration, the double diagonal can have positive vega, meaning an increase in implied vol can benefit it. An iron condor has negative vega, so an increase in implied vol can hurt an iron condor position, all things being equal.

Add a Little Vega

Remember some hard facts about vega. First, it’s highest for at-the-money (ATM) strikes, and gets progressively lower as a strike moves further OTM. Second, it’s higher when an option has more time to expiration, all else being equal. With an iron condor, the short options are closer to the money and have higher vega than the further OTM long options. So, the iron condor is net short vega. With the double diagonal, even though long options are further OTM than short options, they can have higher vega because they have more time to expiration.

You can visualize vega at different strikes for multiple expirations on the thinkorswim^® platform from TD Ameritrade. On the Trade page, go to the Product Depth section near the bottom. Select vega from the dropdown menu, then choose two expirations from the “Series” dropdown menu. In Figure 3, the magenta line shows the vega of OTM options with 60 DTE, and the yellow line shows the vega of OTM options with 30 DTE.

Really, a double diagonal is an iron condor, plus a put calendar and a call calendar.

• Start with a 37/38/42/43 iron condor, which is long the 37 put, short the 38 put, short the 42 call, and long the 43 call with 30 DTE. 

• Add in a long 37 put calendar that’s short a 37 put with 30 DTE, and long the 37 put with 60 DTE.

• Add a long 43 call calendar that’s short the 43 call with 30 DTE, and long the 43 call with 60 DTE. 

The long 37 puts with 30 DTE of the iron condor are offset by the short 37 puts with 30 DTE of the put calendar spread, while the long 43 calls with 30 DTE are offset by the short 43 calls with 30 DTE of the call calendar spread. 

Keep in mind that calendar spreads have positive vega. Adding them to a negative iron condor can create a positive-vega double diagonal. The level of a double diagonal’s positive vega depends on which strikes you select for long options. If long options are closer to the money, like the 37 puts and 43 calls are in this example, it could have a higher vega than if the long options are further OTM, such as the 35 puts and 45 calls. If the long options are far OTM, they could have lower vega than the short options, and give the double diagonal negative vega. 

You can use the Analyze page on the thinkorswim platform to see if a prospective double diagonal has positive vega, and even test how that vega changes as you use different strikes (Figure 4).

Strike selection in double diagonals also determines position risk. The wider the distance between the strikes of the short and long options, the larger the risk. That’s the same as with an iron condor. 

When vol is low, consider the double diagonal’s long vega strategy. If you think implied vols might go higher, but you still like the market-neutral, positive-theta, defined-risk strategy, the double diagonal could be a suitable alternative.

Roll With It

Double diagonals have another unique feature: opportunities to get credits from rolls. Think of it as the gravy with your tasty meat and potatoes. Because a double diagonal’s long options are in a further expiration than the short options, you can try to roll the short options to a further expiration and collect a credit. As long as the short options you roll to don’t expire after the long options, you can keep a double diagonal alive long after an iron condor expires. 

Just like rolling the short option of a long calendar spread, the credits received through rolling a double diagonal’s short options can reduce the risk of the position while potentially increasing its profit. Given the available stocks and indices with weekly options, this increases the number of possible rolls.

For example, if you paid $0.30 debit for that XYZ double diagonal, the max risk is $130. But if you roll the short 38 put and 42 call to a further expiration and collect $0.30 in credit, you’ve reduced the double diagonal’s risk to $100. If you can roll them again for, say, $0.40, you’ve reduced the risk down to $60. The last action is rolling the short options to the expiration of the long options, and you have—drum roll, please—the iron condor. The total roll credit on the double diagonal is the total for the resulting iron condor. Ideally, those rolling credits are higher than what you’d get from selling the iron condor in the first place. 

Credits earned for rolls depend on where the stock price is at the time of the roll, as well as implied vol. When implied vol is higher, credits can be higher, too. So, if you think implied vols will rise, you could potentially collect more. That’s an additional benefit to a double diagonal’s long vega.

Keep in mind that rolls will increase commission costs, which means the double-diagonal strategy may carry more commissions than the iron condor. 

Fill Up on Strategy

Don’t go hungry when vol is low. And don’t toss out your market-neutral, positive-theta, defined-risk style for potentially riskier directional trades. Consider double diagonals as an alternative to iron condors in low-vol market conditions. Then buy a stationary bike and snack to your heart’s content.