Previously in this column, we discussed the diagonal spread. This position involves going long a longer expiry contract and short a shorter expiry contract of a different strike. A diagonal spread is a calendar spread with different strikes. This week, we look at how to continually roll a diagonal spread, and the similarity the spread has with a covered call.

Rolling the strikes

A diagonal spread is set up when you expect the underlying to remain rangebound during the short term and thereafter move up. It would be typical to go long on the next-week (or later expiry) Nifty call and short on the near-week Nifty call. 

But what if you want to continually roll a diagonal spread? You can roll your spread for two reasons. One, when you want to use the diagonal spread as a substitute for a covered call strategy. And two, when your view on the underlying’s rangebound movement extends beyond the current week. 

Consider the covered call, which involves going long on the underlying and short an out-of-the-money (OTM) call. The strategy involves locking-up large capital because you must hold the shares in multiple of the permitted lot size for this strategy to work. What if you want to create a similar position without holding the shares? You can use a longer-dated at-the-money (ATM) call instead of a stock to minimise the need to frequently adjust the position. For instance, you could use the ATM near-month Nifty calls and OTM near-week calls to setup a diagonal spread, and the roll the short calls till a week before the expiry of the long call.

Now, consider the second reason for the roll. Suppose you go long January 30 24300 call and short January 16 24000 call. Depending on the strikes you choose, the spread can be set up for a net credit or a net debit. The position will make handsome gains when the near-week strike expires worthless, and the longer-dated call becomes in-the-money (ITM). 

Suppose the 24000 January 16 option expires worthless, and you believe that the Nifty Index will continue to remain rangebound for another week. You can initiate a new short position on, say, January 23 24100 call; you will carry your long January 30 24300 strike, as you believe that the option will become ITM before its expiry. When the long strike nears expiry, you could close the position and create a new diagonal spread- long the next near-month contract and short the next near-week contract. 

Optional Reading

Depending on the distance between strikes, the position can be long vega and delta. This is because longer-dated OTM strikes typically have greater vega and delta than shorter-dated options of the same or near-same strikes. Note that a diagonal spread can also be ratioed; the position can be set up long one near-month contract and short two near-week contracts. The position will suffer losses if the underlying rises sharply before the expiry of the short-dated strike. 

(The author offers training programmes for individuals to manage their personal investments)