A bullish diagonal spread is an advanced option trade and generally not suitable for beginners, but it can have its place within an option portfolio.
It is a bullish strategy that benefits from time decay and is best placed when volatility is low, such as the current conditions.
The strategy involves buying a long term, in-the-money call and selling a monthly out-of-the-money call against it.
The trade is best placed when the trader has a bullish outlook and thinks the stock could get to the short call strike by the first expiration date.
A rise in implied volatility will benefit the trade as it has positive Vega overall.
The big risk with the trade is a sharp move lower early in the trade.
Let’s look at an example using Tesla (TSLA).
TSLA Stock Bullish Diagonal Example
Tesla put in a solid day yesterday closing up 4.51% and closing above the 50-day moving average.
TSLA stock is also showing impressive accumulation.
Let’s look at how we can use options to find a favorable risk to reward trade on the assumption that TSLA stock might rally to $265 in the next few weeks.
We will look at a bullish diagonal spread which allows traders to get long TSLA without risking too much capital.
A bullish diagonal spread is a trade that involves buying a long-term call option and selling a shorter-term, further out-of-the-money call option.
Structuring the trade at $265 gives the trade around 38 delta, which is roughly equivalent to being long 38 shares of the stock.
Selling the December $265-strike call option will generate around $340 in premium and buying the June 2024, $240-strike call will cost around $4,230.
That results in a net cost for the trade of $3,890 per spread, which is the most the trade can lose.
The estimated maximum profit is around $1,380, but that can vary depending on changes in implied volatility. The maximum profit would occur if TSLA closes right at $265 on December 15.
The trade benefits from time decay as the short-term option will decay at a faster rate than the longer-term option.
The ideal scenario for this TSLA trade is for the stock to stay above $245 for the next few weeks.
A bullish diagonal spread is a good way to gain some upside exposure on a stock without risking too much if the move doesn’t eventuate.
The suggested stop loss level is a close below $235.
Here is a visual of what the trade looks like:
Barchart Technical Opinion
The Barchart Technical Opinion rating is a 56% Buy with an Averageshort term outlook on maintaining the current direction.
Long term indicators fully support a continuation of the trend.
The market is approaching overbought territory. Be watchful of a trend reversal.
Implied volatility is at 42.37% compared to a 12-month low of 39.30% and a 12-month high of 95.99%.
Please remember that options are risky, and investors can lose 100% of their investment. This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
On the date of publication, Gavin McMaster did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
