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.
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The strategy involves buying a longer-dated call and selling a shorter-term 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 Rocket Lab Corporation (RKLB).
RKLB Stock Bullish Diagonal Example
Rocket Lab Corporation is in the midst of a strong rally and is rated a Strong Buy.
The Barchart Technical Opinion rating is a 88% Buy with a Strengthening short term outlook on maintaining the current direction.
Long term indicators fully support a continuation of the trend.
Relative Strength is above 70%. The market is in overbought territory. Watch for a potential trend reversal.
Let's look at how we can use options to find a favorable risk to reward trade on the assumption that RKLB stock might rally to $85 or above in the next five weeks.
We will look at a bullish diagonal spread which allows traders to get long RKLB 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 24 delta, which is roughly equivalent to being long 24 shares of the stock.
Selling the January 16th $85-strike call option will generate around $395 in premium and buying the February 20th, $75-strike call will cost around $1,190.
That results in a net cost for the trade of $795 per spread, which is the most the trade can lose.
The estimated maximum profit is around $650, but that can vary depending on changes in implied volatility. The maximum profit would occur if RKLB closes right at $85 on January 16th.
The trade benefits from time decay as the short-term option will decay at a faster rate than the longer-term option.