Diagonal vertical spread

I'm trying to understand the risk/reward of a diagonal vertical spread where I'm long the near-term and short the back-month.


Theoretical example: long the 40 apr call short the 50 july call with xyz at $35

Can anyone break done this spread at near term exp with a few different stock price outcomes? I understand my theta decay and the exposure to an increase in vol.

Thanks

 

It's a diagonal spread not a diagonal vertical spread.

A diagonal spread where you long the front month and short the back month can be broken down into a long 40/50 call vertical in July and a reverse 40 call calendar in April.

Essentially, you want the stock to be away from 40 on April expiration and preferably to the upside.

 

The easiest way to see the R/R is from a graph. I think the CBOE offers one in The Option Toolbox.

Plan B: If you can determine the delta of each option at various prices, you can chart it by subtracting the Jul 50c's delta from the Apr 40c. Since the Apr 40c has a higher delta than the Jul 50c and will increase more as XYZ rises, you want XYZ to rise dramatically.

With the more rapid decay rate in the Apr 40, the worst event is XYZ at 40 ... as the Apr 40c goes to zero and the July 50c appreciates a bit.

A crash in XYZ will drive both premiums toward zero and the end result would be whatever credit/debit the position was opened for.

And as you implied, volatility change shifts performance vertically.

 

Keep in mind as well that since you're short the *back* month, you'll be considered naked by many brokers, even though you're technically hedged with the front month long.

I guess the reasoning is that if you're waffled by a bus (i.e. can't manage trades for some period of time), your hedge will expire before the short does, thus leaving you naked.

 

Thanks for all the responses.

Now let's say xyz is it at 50 at april exp and the spread was done for a very small debit. The 40 calls are worth 10 bucks. The back month would be worth at least $10 plus time value therefor I am at a loss. How can I roughly determine my upside breakeven at April exp?

If I choose to take delivery at April exp it is essentially a buy-write, but if I exit the spread all together at nerm-term exp, I need some major movement but the question is how much etc..

Thanks

 

There is always a possible underlying behavior for any option strategy that makes this strategy successful and, of course, there is always a pattern that could make an option strategy to fail. But generally, there is always a slight advantage to be long further month’s options and short closer month’s ones. However, what makes one strategy better than other is its reaction to the most probable underlying security trading pattern. Keeping in mind overall higher vol levels these days, I would be inclined to put up credit spreads with the very tight roll out policy rather than debit spreads. What is also important is to assess the IV skew between OTM puts and calls for any particular security.

 

You can't do that spread for a debit as the July call will always be worth more than the April one, unless you feel like giving away free money.

 

How will the back month be worth at least $10 plus time value? It's a Jul 50c with XYZ at 50. There's no intrinsic value.

Get your hands on a charting program. A picture is worth a 1000 words... maybe even a lot more when trying to describe an option position.

 

I think that at higher IV, the back month should exceed the front month.

 

My mistake on the description.