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. ...