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 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.
The ideal scenario for this RKLB 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 $70.
Here is a visual of what the trade looks like:
Company Details
Rocket Lab Corporation is a space company which provides launch services and space systems solutions principally in the United States, Canada, Japan and internationally.
Rocket Lab Corporation, formerly known as ROCKET LAB USA, is based in Long Beach, California.
RKLB rates as a Strong Buy according to 8 analysts with 1 Moderate Buy rating and 6 Hold ratings.
Implied volatility is at 82.63% compared to a 12-month low of 66.33% and a 12-month high of 132.10%.
Robinhood is due to report earnings on February 26th.
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.
On the date of publication, Gavin McMaster did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
More news from Barchart
- RKLB Stock Bullish Diagonal Trade Targets a Price of $85 by January 16th
- Broadcom (AVGO) Stock Options Are Signaling Pensiveness. Here’s Why the Fear Might Be Unwarranted.
- Occidental Petroleum Stock Has Tanked - But It May Hike Its Dividend - Time to Buy?
- Dogs of the Dow Enhanced Income Strategy with Covered Calls
