Diagonal Spread

The diagonal spread is frequently used as a "roll" trade. In other words, the diagonal will often involve selling (buying) a short-dated option to close while buying (selling) a longer-dated one to open. Nevertheless, both legs of the trade can also be initiated simultaneously. In any case, the trade involves two options of the same type (put or call) but with differing expirations and strikes.

From the perspective of a roll, a common example of a diagonal is as part of a long-term overwriting strategy. This is when you own a stock that you want to keep, but want to generate an ongoing income stream by selling calls against it. In some cases the written calls will expire worthless. On the other hand, the stock will perform quite and in order to keep it, you will have to cover the written call.

Let's say you own ABC and wrote a July 50 call against it. The stock has gained ground and is now sitting at 52 just a week before expiration. You do not want to be called out of the stock - perhaps you have a large potential tax gain that you want to avoid, or perhaps you simply think the stock will continue a slow upward climb that is well suited to a continuous overwriting strategy.

So you look for a higher-strike longer-dated call to write. You don't want to go out too far and thus relinquish upside for an overly extended period, but you want to take in enough premium to pay for most, if not all, of the call you have to buy back. (Note that you may always choose to buy back the call you have previously written, even if it is well out of the money. While you will incur a commission that seems unnecessary, your broker will likely require you to do that to avoid the capital charge associated with being short a naked call once you have written the longer-dated call).

You see that it will cost you $2.10 to buy back the July 50 call. Meanwhile, you can write an October 55 call and collect $2.05. Thus, before commissions, it will cost you only a nickel to keep your stock. Meanwhile, the new trade will be a net winner unless the stock goes up more than 10 percent over the next three months. Since you are looking for slow growth - closer to 10 percent than 40 percent annualized - this trade makes sense.

With most multi-legged option trades, you will always know ahead of time whether the strategy you want to put on is a credit or debit trade. This is not the case with diagonal spreads. Each trade must be reviewed independently, because you cannot say ahead of time whether the strike price or time difference will have a larger effect on the options' prices. Thus it is nonsensical to speak generically about "diagonal credit spreads" or "diagonal debit spreads." At the same time, it is especially important to take particular care in placing orders and making sure your broker knows exactly what you are looking to do.

When both legs of the diagonal are being initiated at the same time, the thought process is somewhat (though not completely) different. If you are longer-term bullish but short-term neutral on a stock, the diagonal spread (selling a short-dated call and buying a longer-dated one with a higher strike) can be a very effective way of leveraging this view. You may well be able to put this position on for a modest credit, depending on the individual situation.

But you must be willing to accept the fact that if you are right about direction but wrong about timing, you will end up losing roughly the difference between the two strikes. This is because with diagonals, as with their cousin - the calendar spread - a big move before the first expiration benefits the trader who bought the shorter-dated option and sold the one with more time to expiration.

For example, let's say XYZ Corp. is trading at 49. You don't expect the stock to do much over the next month, but earnings are coming out in two months and you think the stock could really run. You sell a one-month call struck at 50 and buy a three-month call (two-month calls, we'll stipulate, are not available) struck at 55. It turns out that by selling a lower strike than you are buying, you are able to buy the extra two months of option life and take in a small credit. You get $1.35 for the one-month 50-strike call while you pay $1.15 for the three-month 55-strike call, taking in $0.20 before commissions

First, let's say things play out ideally for you. XYZ is trading at $49.75 in a month when the first option (the one you sold) expires worthless. Now the call you still own has two months of life remaining and is trading at $0.85. This is on a position that you were paid $0.20 to initiate a month earlier. Should you sell the remaining option, your pre-commission profit would be $1.05. Since the capital required for this trade would be the difference between the two strike prices, your return would be 1.05/5 or 21 percent.

Notice that if you had simply bought the 55-strike call, you would have already lost more than a quarter of your option value (from $1.15 to $0.85). Using this strategy helps you pinpoint the investment to your anticipated time horizon and thus avoid spending premium you don't want to pay.

Of course, that's what happens when you are right. Now let's consider a worst-case scenario. Before the first option expires, the company comes out and pre-announces that earnings are going to be far better than anyone was anticipating. Analysts rush to upgrade the stock and it trades up to 57.

Now you are essentially forced to unwind your trade, because the calls you sold are almost certain to be exercised against you. You would thus end up owning a 55-strike call against being short a $57 stock. This is equivalent to owning a slightly out-of-the-money put on a stock you probably still like - certainly not a position to be in. If you unwind the trade now, you have to pay $7.20 for the call you are short, while you get $4.30 for the call you are selling. This net $2.90 outflow leads to an ultimate loss on the trade of $2.70, or more than half the capital risked.

While this is not a pleasant outcome, it's probably better to take your medicine now than to hold on to a trade you never wanted. Unless the stock trades sharply below 55 before your long option expires, you are likely to lose the $2.30 in time value the option currently has ($4.30 market value less $2 intrinsic value, 57-55).

Because of the possibility of such an outcome, you should be careful when using diagonal spreads.