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Why Now's the Time to Try a Double Diagonal


An option strategy for the end of the year and beyond.

So the S&P 500 Index continues to be traded with 1090 to 1100 range, which is enveloped by much more important 1080 and 1120 support and resistance levels. In trying to formulate a trading strategy, the two basic questions seem to be: In which direction will the market break, and how long can it remain within the recent range?

Working backward, my answer to the latter is "indefinitely." While it certainly would seem that a measurable move higher or lower is inevitable, there's no reason that the market can't continue sideways longer than you can draw lines on the chart. As to the former, I have no idea. Fundamentally, it would seem that prices have gotten ahead themselves, but there's no denying that the triumvirate of low interest rates, massive liquidity, and an intact bullish trend are still in place.

That said, my job is to do -- not to describe -- the obvious. So here's an option strategy that I think will bridge the two scenarios of a continued range-bound market over the near term, with expectations of an eventual strong directional move up or down.

Double Up and Down

The strategy I'm looking at is often referred to as a double diagonal. It consists of selling a strangle with a near-term expiration while also purchasing a strangle with a longer-term expiration date.

Looked at another way, the double diagonal is the simultaneous purchase of both a bullish and bearish calendar spread. The diagonal part of the descriptor comes from the fact that it usually involves different strike prices.

The concept of a calendar spread is to sell a near-term option to help finance or reduce the cost of the longer-dated option that's purchased. The position benefits from a sideways or drifting market over the short term as time decay of the short front month accelerates relative to the option owned. Ultimately, you want to be left outright long the later-dated option on a reduced, or even no-cost, basis.

In doing this for both bullish and bearish positions, the strategy ultimately will leave one net long a strangle and positioned to benefit from a new sustained trend in either direction.

For example: Let's assume one thinks Apple (AAPL) could meander between $190 and $200 for the next few weeks as investors await both holiday sales results. With shares around $193, one could sell the December $190 put and the December $200 call for a total $3.80 net credit. Now add in the assumption that once-monthly sales data become available, and fourth-quarter earnings results are released -- which should be around the third week of January -- that the stock will break out of that range.

In this scenario, the purchase of a January strangle -- such as the $190 puts and $200 calls -- would make sense. That January strangle is currently trading around $13.20, meaning the two calendar spreads could be purchased for a total around $9.40 net debit. This means shares of Apple would have to be above $209.40 or below $180.60 on the January expiration for the position to be profitable.

It seems reasonable, maybe even probable, that Apple will either make a new high in the next two months or resume another leg down.

Similar positions might make sense in other names such as Amazon (AMZN) or Priceline (PCLN) that have pulled back after recently hitting all-time highs.

Spying Quarter's End

For my part, I'm going to look at establishing a double diagonal Spyder Trust (SPY) on the notion that the market could stay range-bound through the remainder of the year, but should break out of the range in early January -- which tends to have strong directional moves as money gets put to work and earnings reports begin to flow in.

The added attraction of the Spyders is that they offer quarterly options -- that is, a series that expire at the end of the month as opposed to the third Friday. In this way I can get two, two-week cycles of front-month options sold, which should substantially reduce the cost of the January options purchased.
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No positions in stocks mentioned.

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