Diagonal Spreads 101

The most commonly traded spreads use options that expire in the same month. However, there are times when it is advantageous to own positions that expire in different months. Let’s use options trading information to take a look at one such spread, the diagonal.

Definition: A diagonal spread is a strategy involving the simultaneous purchase and sale of two options of the same type (both calls or both puts) that have different strike prices and different expiration dates.

When a trader purchases the longer-dated option, he or she buys the diagonal spread. A word of caution: There is no “official” nomenclature in the options world, and you may discover situations in which a speaker uses a different definition.

Typically, the strategy behind the spread is to sell a shorter-term option, with the expectation that it expires worthless. Because selling naked options is a relatively risky way to trade, the trader buys an option that is further out of the money than the option sold. That establishes a maximum loss for the trade and is an example of prudent risk management. 

Why not buy an option that expires in the same month as the option sold, thereby selling a vertical call (or put) spread? 

1. Once the short option expires, the yet-to-expire option can be sold.

2. Under the right conditions, buying the diagonal spread can result in far more profit than selling the call or put spread. However, under less than ideal conditions, the diagonal spread loses money when selling the call or put spread would have been profitable

Diagonal Spread Example

Note: This example is for educational purposes only. It is NOT a recommendation.

Buy 10 AAPL Aug 290 Calls @ $4
Sell 10 AAPL July  270 Calls @ $3.80
AAPL is currently $247

When July expiration arrives, if AAPL is below $270 and the July calls are worthless, the trader sells 10 AAPL Aug 290 calls. The final profit or loss from the trade is determined by the price one can receive when selling those calls.

The premise behind buying the diagonal spread is as follows:

• The cost to open the trade is minimal; 20 cents in this example. Often a cash credit is collected.

• There is almost zero risk if the stock moves lower because the maximum loss is the small debit paid. If a credit is collected, then no loss is possible on a stock price decline.

• If implied volatility (IV) of AAPL options is “high” when it comes time to sell the August calls, then the premium collected will be attractive. If IV is “low” then the sale price will be disappointing.

The risk in trading this position becomes apparent when the stock rallies, and it gets worse when IV falls at the same time. When short the 270 calls, the trader accumulates short deltas quickly as the stock moves through the strike. It’s difficult to determine the maximum risk, but the July 270 call can be as much as 20 points higher than the Aug 290 call — minus the time premium in the August call. Because this is not a small loss, the prudent trader may decide to exit early when the stock rallies. Deciding what to do and when to do it comes under the heading of risk management.

Follow Mark Wolfinger on Twitter @MarkWolfinger.

Article printed from InvestorPlace Media, https://investorplace.com/2010/07/diagonal-spreads-101/.

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