Real-World Trading: The Diagonal Spread, Part 2

Last week I discussed the details of a diagonal spread. This strategy is similar to a calendar spread, but instead of selling and buying the same strike, you're selling a strike that's different from the one you buy. Different traders use different techniques for diagonal spreads, with diversity a key component of using this strategy.

Some traders prefer to sell a higher-strike call and buy a lower-strike call. You'd want to find at least a 15% skew between these options before entering a diagonal on them. The idea behind selling the higher-strike call is that you have room for short-term growth. For example, if you buy a 20 strike call and sell a 25 strike call, the long call can gain $5 before expiration, and you still get to keep the entire premium from the sold option. However, this also means that you aren't going to get a lot of premium up front, because the sold option is further out of the money.

Another strategy is to sell a lower-strike call and buy a higher strike. In this case, you can often even get a credit, with the risk being that the stock moves above the short call before expiration. We'll use this strategy for our mock trade this week.

Last week I showed a graph of Dreyer's Grand Ice Cream (DRYR Quote) as an example of a diagonal spread. I searched Tuesday for candidates for a diagonal trade, and Dreyer's was listed over and over. Therefore, I decided to use this stock for our mock trade.

Dreyer's is showing a large skew between option months because of an impending takeover by Nestle. The merger announcement was made last June, but the proposed deal has been experiencing regulatory problems. If the merger is approved, Dreyer's shareholders would get about $83 a share for their stock.