A diagonal spread is a hybrid of a vertical spread and a calendar spread. A diagonal spread buys one option and sells another option of the same type (put or call) but with a different expiration and a different strike price. It can take advantage of differential erosion by time to expiration, as we discussed in Chapter 6 when we examined
FIGURE 15.2 A Married Put on Netflix (NFLX)
calendar spreads, as well as the lower cost of a vertical spread. A long put diagonal can also take advantage of the relatively higher implied volatility of out-of-the money puts. Figure 15.3 shows how we might construct a call diagonal in XLF, the financial sector exchange-traded fund (ETF).
The resulting diagonal is long the June 22 strike call and short the May 23 strike call. This long call diagonal cost 0.46, and that's the maximum loss. The maximum
FIGURE 15.3 A Call Diagonal in XLF
gain is unlimited if the May call expires worthless because the resulting position is long the June call outright. The diagonal is nearly 25 percent cheaper than the June call by itself.
Charting the payoff for this call diagonal would require us to make many assumptions about where XLF was when the May option expired, the same sort of assumptions we discussed in Chapter 6 when we examined calendar spreads, so we won't draw a payoff chart but the goal for this diagonal is, as it is with a calendar spread, to have the front option expire worthless leaving us long the longer-dated option outright.
A butterfly is a spread of two spreads; all the options are the same type and they share a center strike price. We discussed butterflies in Chapter 11. A condor is a spread of two spreads; all the options are the same type but they don't share a center strike price. We discussed condors in Chapter 12. An iron condor is a spread of two spreads; one spread is a call spread and one spread is a put spread and they don't share a center strike price. We discussed iron condors in Chapter 12. An iron butterfly is a spread of two vertical spreads; one spread is a call spread and one spread is a put spread, but they share a center strike price. Figure 15.4 shows some options in Exxon Mobil (XOM) that we might use to construct an iron butterfly, sometimes called simply an iron fly.
FIGURE 15.4 An Iron Butterfly on Exxon Mobil (XOM)
FIGURE 15.5 An Iron Butterfly in Exxon Mobil (XOM)
The goal is to collect most of the premium from selling that central straddle, the 95 straddle in XOM, while defining risk by buying that 85/105 strangle.
Figure 15.5 shows the payoff chart for this 80/95/110 iron butterfly in XOM.
An iron butterfly is usually constructed as you see in Figure 15.4, which sells the body and buys the wings to create a trade that collects premium and that's likely to generate a profit but that limits potential losses. Notice that the maximum potential loss is nearly double the maximum potential profit. You would only execute this trade if you expected little volatility.