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A bullish diagonal spread is an advanced option trade and generally not suitable for beginners, but it can have its place within an option portfolio.
It is a bullish strategy that benefits from time decay and is best placed when volatility is low, such as the current conditions.
The strategy involves buying a long-term call and selling a monthly out-of-the-money call against it.
The trade is best placed when the trader has a bullish outlook and thinks the stock could get to the short call strike by the first expiration date.
A rise in implied volatility will benefit the trade as it has positive Vega overall.
The big risk with the trade is a sharp move lower early in the trade.
Let’s look at an example using Robinhood Markets (HOOD).
HOOD Stock Bullish Diagonal Example
Robinhood Markets looks to be sparking back up after crossing above the 50-day moving average on Monday.
Of the 24 analysts following Robinhood 15 have a Strong Buy rating, 2 have a Moderate Buy rating, 4 have a Hold rating and 2 have a Strong Sell rating.
Let’s look at how we can use options to find a favorable risk to reward trade on the assumption that HOOD stock might rally to $85 in the next six weeks.
We will look at a bullish diagonal spread which allows traders to get long HOOD without risking too much capital.
A bullish diagonal spread is a trade that involves buying a long-term call option and selling a shorter-term, further out-of-the-money call option.
Structuring the trade at $85 gives the trade around 32 delta, which is roughly equivalent to being long 32 shares of the stock.
Selling the June 18th $85-strike call option will generate around $405 in premium and buying the July 17th, $70-strike call will cost around $1,335.
That results in a net cost for the trade of $900 per spread, which is the most the trade can lose.
The estimated maximum profit is around $675, but that can vary depending on changes in implied volatility. The maximum profit would occur if HOOD closes right at $85 on June 18th.
The trade benefits from time decay as the short-term option will decay at a faster rate than the longer-term option.
The ideal scenario for this HOOD trade is for the stock to move towards $85 in the next few weeks.
A bullish diagonal spread is a good way to gain some upside exposure on a stock without risking too much if the move doesn’t eventuate.
The suggested stop loss level is a close below $73.
Here is a visual of what the trade looks like:
Company Details
Robinhood Financial LLC is a registered broker dealer. Robinhood Securities, LLC provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading.
Implied volatility is at 59.51% compared to a 12-month low of 49.53% and a 12-month high of 90.94%.
Robinhood is due to report earnings on July 29th, so this trade should not have any earnings risk.
Please remember that options are risky, and investors can lose 100% of their investment. This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
