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What Is A Diagonal Spread?

Posted by Pete Stolcers on November 4, 2008

In today’s option trading blog I will dicsuss diagonal spreads. A diagonal spread combines an equal number of longer term options and shorter term options with different strike prices. The term actually comes from the way the options were listed in the newspaper. If you connected the two strikes, a diagonal line would run across the page. In a traditional sense, you are long the longer term option (the anchor leg of the spread) and it is closer to the money. By rule and regulation any other combination would involve considerable margin.

For instance, if you were long a May 65 call and short an August 80 call, the August 80 call would be considered naked. That would require the highest level of option trading approval from your brokerage firm and considerable margin would be posted. If you were short the May 65 calls and long the August 80 calls, the position is covered, but you would have to satisfy the 15 point margin requirement (difference between the strike prices).

Let’s take a final look at the PCAR trade I have referenced during the last two articles. At one point in the trade, I was long the August 65 calls and short the June 80 calls. That is a traditional diagonal spread and it is the type I will be discussing.

From my perspective, the intent of the diagonal is to take advantage of front month time premium decay while still giving the trade some room to move. Using a bullish example, it would be similar to a covered call position where you are long the stock and short an at-the-money (ATM) or out-of-the-money (OTM) option. In order to achieve this, the back month option needs to be deep in-the-money.

Given that there is more time until expiration on the anchor leg of the spread, the option will carry more time premium. In order for me to reduce that I have to go further and further ITM to find an option that is trading close to intrinsic value. The more volatile the stock, the richer the premiums, the deeper you must go for the long leg of the trade. Again, with reference to the PCAR trade, I bought the August 65 calls ($9.80) that were two strikes ITM and I still had to pay $2.80 in time premium (stock was $72). The disadvantage was that even with an ITM option, I still had to pay time premium. The advantage was that the front month OTM options that I might sell, also carried a lot of premium.

In the end, this strategy if properly constructed will act like a covered call where you are long stock and short a call option. However, there are a few distinct advantages to the diagonal spread.

1. You don’t have to put up the stock margin, you just have to pay for the spread.
2. The risk on the position is limited to the price paid for the spread (not the price of the underlying stock less the call credit).
3. The ITM option will eventually implode with time premium if the position moves against you. To learn more about this concept read Buying In-the-Money Options – A Hidden Benefit.

Keep in mind that you are not entitled to dividends with this strategy and that the bid/ask spread of the ITM option will probably be much wider than the underlying stock. Slippage and dividends are two possible limitations.

In the next article, I will write about how I trade diagonal spreads.

If you’ve tried one, share your experience and comment.

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Option Trading Comments

  • On 01/12, Khan said:

    Excellent article and a strategy I am interested / toying over.
    Assuming my view on the Pete,
    First excellent website.
    Next good article and a strategy I am interested / toying over, so hope you can answer my question.
    Assuming my view on the instrument is bullish (e.g. oil stock may go down another 5% but long term (over 9 months should increase).
    Similar to what you posted, I am looking to buy long dated calls deep ITM (so as to have a high delta) and sell OTM calls, medium dated.
    As of today (jan 10 2007), stock is at 925 (London prices), and thinking of buying 850 Dec calls at 95 (so 20 time value), and selling 950 Sept calls at 35. My risk is 60. The strike difference is greater then my risk so if stock moves above 950 at any time I make a profit.

    I see following outcomes,

    a) If stock is above 950 I will make some profit, even I i have to exercise (which is worse case)

    b) If i am below 950 (around sept) i can let short sept call expire worthless and sell Dec 950 call to collect more premium, say another 20, so premium cost now is 40.

    c) If I am in 940-960 range (around sept) I could roll my short Sept call over to Dec call to collect further premium, albeit less than (b), say 15 so premium cost is now 50.

    d) Hoping this doesnt happen, but have to cater for all eventualities, if stock goes down (over period of time) by large amount (say to 850 - 8% decline), then number of possibilities,
    (i) I should be able to close out Sept short 950 call (as this is now deep OTM, me thinks!!),
    (ii) Then either wait for recovery (as this is a major Oil stock, and long term view and volatile market price will go up at least some (if not to come down again), but when it does sell another OTM call and collect more premium
    (iii) not wait and buy higher priced 900 (IV should have rocketed). As I need to ensure that my strike differences (now 50) is greater than premium, I need to ensure that I collect more than 10 (to reduce initial 60 premium to 50)
    (iv) Worst case due to increase in IV I maybe even able to close out my long Dec 850 call for 60 (me thinks, although I should price this up), so that my loss is very minimal to the cost of closing the short Sept 950.

    If you are still with me then well done. You may ask what is the point of all this - waiting for a question?

    From what I can see as long as one selects a bullish stock, (or even volatile stock, and most are as nothing moves in a straight line) this seems a pretty good strategy.
    If (a) occurs then some profit made, any of (b) or (c) reduces premium paid (collecting more premium) and still waiting for stock to close above breakeven (900-915). Risk wise (case d) could still be closed out for a small loss or wait to break out for no loss, by also making use of IV.

    Am I missing something in my logic?

  • On 01/12, Khan said:

    Pete I just reread, and not to confuse you but (d) (iii) should read “not wait and SELL higher priced 900 (IV should have”.....

  • On 01/18, Pete said:

    Hi Khan,

    Your uderstanding of the strategy is fairly accurate. The main thing to keep in mind is that the long term view of the underlying has to remain intact. You make reference to damage repair strategies if the underlying moves against you. Before you get to that point, you have to have a stop level for the long “leg” so that you can close the trade down, admit that you were wrong and step aside. There are bacically 3 outcomes. 1. The stock moves big in your direction. That is good and you will make at least the difference in the stike prices less the debit you paid. 2. The underlying drifts closer to the short strike and the short strike expires. This is the best case. You can take profits on the long or sell another option against it. 3. The stock moves against you. If it is a small move, you can stick with it and wait for a better price before selling options against it or close the trade for a small loss. If it moves big against you, you have to close the trade. Don’t wait for the short leg to expire, close it down. With regards to oil, you need to identify a support level for the stock. If it is breached, get out.

    Hope this helps.

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