Diagonal call spread
Diagonal call spread is an option strategy involves in buying an in the money call option of a long expiry and selling a higher strike call option of the near moth.
This strategy is similar to bull call spread where both strike prices for both call options are equal. In both strategies the long term outlook is bullish. In a diagonal call spread the trader has a neutral to mild bullish view on short term market movement.
Let’s analyze the strategy with an example.
Nifty has closed at 8243 on Jan 06 2017. As a trader you are expecting Nifty to scale up and reach 8700 by end of March. You can construct a diagonal spread by
- Buy Nifty Mar 8200 CE at 292
- Sell Nifty Jan 8300 CE at 75
The total cash outflow to create your position with a single lot of Nifty will be ( 292 – 75 ) x 75 = 16275. Your account will get debited with Rs. 16275 and this will be your maximum loss in any adverse market condition.
Let’s test our strategy at various market conditions. We will consider the following three market conditions during the life of our spread.
- Nifty stayed at 8250, below your higher strike of 8300 till Jan expiry.
- Jan 8300 CE will expire worthless an you keep the premium 75 x 75 = Rs. 5625.
- In the Month of Feb you again sell Feb 8300 CE at around 100. You earn 75 x 100 = Rs. 7500 if Nifty stayed below the strike price.
- In march Nifty rallies to 8600 as you expected. On March month expiry your 8200 CE will have an intrinsic value of 400 points. You have spent Rs. 292 to purchase it. So the net profit will be ( 400 – 292 ) x 75 = Rs. 8100.
So the total profit made from continuing restructuring your position is 5625 + 7500 + 8100 = Rs. 21225.
As we see in the earlier section, the total loss is fixed to the initial cost involved in constructing the strategy which is Rs.16275. It is not a small amount but if your predictions are right then you have the potential to earn 50% returns on your investment in 3 moths.
In market, risk is directly proportional to reward. The more risk you take, the more reward you receive. Learn lower risk strategies first and master them before jumping into risky strategies. Wait for another strategy in my next post.
Hope this article helped you to tune up your trading skills. Happy reading…