"Amateurs want to be right. Professionals want to make money."


— Alan Greenspan

Introduction

The short diagonal strategy is a less common yet potentially profitable trading approach. Unlike the long diagonal, this strategy involves selling options with longer expiration dates while buying shorter-term options for protection. It's a great tool to have in your trading arsenal, offering versatility and the ability to manage risk effectively.

What is a Short Diagonal?

A short diagonal is constructed by:

1. Selling a call or put with a further-out expiration date.

• • These options tend to be pricier, which generates a significant credit.

1. Buying a call or put with a nearer expiration date as protection.

• • This ensures limited risk in case of unfavorable moves.

Key Characteristics:

• The trade is credit-generating.
• It exhibits a directional bias, typically bullish or bearish, depending on the strikes and option types chosen.
• It is Vega negative, meaning rising implied volatility (IV) negatively impacts the trade.

Constructing a Short Diagonal

Here are the steps to create this strategy:

1. Select a stock or ETF:

• • Look for underlying assets with high-priced options. For example, Carvana (CVNA) and Marathon Digital Holdings (MARA) often have options with elevated premiums.

1. Sell a longer-dated option:

• • Example: Sell a call or put with an expiration date around 100 days out.

1. Buy a shorter-dated option for protection:

• • Example: Buy a call or put with an expiration date closer to 30 days.

1. Analyze the profit/loss graph:

• • A strong directional bias will typically appear on the graph.
  • The risk is limited, and the reward potential outweighs the risk if the stock moves favorably.

Managing the Trade

Adjusting Strike Prices

Experimenting with different strike prices for the bought and sold options can influence:

• Risk/reward ratio
• Breakeven points
• Overall profit/loss profile

For example:

• Changing the protective option from a $15 strike to a $14 strike could alter the graph significantly.

Post-Expiration of the Short Option

Once the long (protective) option expires, consider managing or closing the short position based on:

• Remaining premium
• Market outlook
• Changes in implied volatility

Impact of Implied Volatility

Since the short diagonal is Vega negative:

• Increasing IV hurts the position, as the longer-dated sold option is more sensitive to Vega.
• Decreasing IV benefits the trade.

If you anticipate a rise in implied volatility, consider alternatives like buying outright puts or calls instead.

Practical Tips

1. Paper Trade First:

• • Use a simulated account to practice placing short diagonal trades and adjusting their components.

1. Choose Stocks Carefully:

• • Avoid stocks with unpredictable or fundamentally bearish setups unless the technical chart supports the trade.

1. Review Metrics:

• • Always check max gain, max loss, and breakeven points to ensure favorable trade metrics.

Conclusion

The short diagonal is a versatile strategy that balances risk and reward. By selling expensive, longer-term options and purchasing shorter-term protection, traders can create profitable setups under the right conditions. However, understanding implied volatility's impact is crucial for optimizing this strategy.

Practice diligently in your paper account to build confidence and refine your approach. Once you're ready, stay tuned for the next topic: The Poor Man’s Covered Call, another powerful diagonal strategy.

As an additional resource, there is a video covering this entire topic which may include some additional content. Click below to view it.