Real-World Trading: The Diagonal Spread

One of the biggest advantages of trading options is the ability to create numerous strategies that can fit your risk profile and market outlook. However, this flexibility comes at a cost, which is time. Because so many strategies can be implemented using options and stocks, we need to spend time understanding them.

I particularly like options because they allow us to hedge risk while still achieving solid profits. If we choose to trade only stocks, we're limited to bullish or bearish outlooks. But stocks often trade sideways, meandering back and forth in a range. We're looking for this type of movement -- or lack thereof -- in a stock when we're interested in entering a diagonal spread.

Before going into the details, I'll first define a spread in general. We often hear the term vertical spread or horizontal spread, so let me explain why these spreads are so named. When options were first introduced, a trader would find these on an options chain. The strikes would be listed vertically, while the months would be listed horizontally. When we trade a vertical spread, we are using the same months, but different strikes. Horizontal spreads use the same strike, but different months.

Thus, a bull call or bear put spread are considered vertical spreads, while a calendar spread is also called a horizontal spread. When we use different strikes and different months, we are moving diagonally across the page, thus the name diagonal spread.

There are various ways to use a diagonal spread, but for our purposes, we'll discuss the normal use of a diagonal spread. This is when we sell a front-month, lower-strike call option and buy a longer-term, higher-strike call option or when we sell a front-month higher-strike put option and buy the longer-term, lower-strike put. Here's a basic risk graph of a diagonal call spread.

Diagonal and calendar spreads use two different expiration months. Thus, the risk graph is a picture of the trade at the time the front-month option expires.

When looking at any strategy, ask yourself when to use it to your advantage. For diagonal spreads, look for stocks that you think will consolidate for some time and then move sharply in one direction or the other. If you feel the move will be up long term, then you'd want to use calls.

You would use puts if your outlook is flat and then down. In order to maximize your profits, you want to sell options that are overpriced and buy options that are underpriced. You'd find this out by looking at the implied volatility, or IV, of the stock's options.

You'd like to see a skew between the IV for the front-month options and the back-month options. Just like when trading calendar spreads, you'd like to see this skew at 15% or greater. As the IV comes down on the overpriced front-month option, your profits increase. However, the largest advantage to a calendar or time spread is the passage of time.

We often discuss how we don't want to buy options with fewer than 45 days until expiration. This is because time decay accelerates the last month of an option's life. By selling front-month options, we get to keep the premium received as long as the option doesn't move into the money at expiration. Thus, each month you feel the stock is going to consolidate, you can sell another month of premium to pay down the cost of the long-term option.

The initial cost for a diagonal spread will normally be less than for a calendar spread. This is because we are buying a further out-of-the-money call or put. However, because there is risk between the sold option and the purchased option, your broker will require a margin account. However, the amount at risk is only the difference between strikes, so the margin required should be minimal.

One reader posted the following trade on my discussion board on Optionetics.com.

  • Dreyer's Grand Ice Cream ( DRYR)
  • Sell 1 APR03 70 Call @ 2.3
  • Buy 1 SEP03 75 Call @ 1.3
Here is the risk graph for this trade as of the entry date:

Dreyer's is showing high IV for the front-month options because of an impending buyout. If the deal goes through, the stock could soar to the $85 level, but if it doesn't, it's likely to consolidate at a lower price. Nonetheless, while the debate continues about the buyout, this diagonal spread has little risk. You won't normally get a credit for entering a diagonal spread, but it all depends on the strikes and IV of the options.

Overall, you can use diagonal spreads much like calendar spreads. You want to find stocks that are likely to consolidate for a few months before making a move. It also helps to have at least a 15% skew between the sold and purchased options.

By Jody Osborne, senior writer and options strategist at Optionetics.com.

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