Diagonal spreads are a great long term way to both invest with options and produce some monthly cash flow at the same time. Many traders actually don’t know much about how powerful and flexible these diagonal spreads can be for an option trader.
Diagonal option spreads are established by entering both a long and short position in two options of the same type (so either two call options or two put options) but with different strike prices and expiration dates. Again take a second to digest that and read it again if you need to. In effect, the strategy is similar to a covered call, except that a long call is substituted for the stock.
Spreading Time And Strikes
This strategy gets the name “diagonal” because it combines a horizontal spread, which represents differences in expiration dates, with a vertical spread, which represents differences in strike prices. You could even think of it as the off-spring of a calendar spread and a vertical spread.
Simply put once again to drive home the point, you buy an option that will not expire for many months and then sell options that will expire in the front month against the current long option. Thus you get exposure both in difference contract months and strike prices. Starting to make a little more sense now?
"Love Your Diagonal" - thinkMoney
Thinkorswim recently just ran a great article in their recent quarterly publication thinkMoney that I urge you all to check out if you haven’t already.
AAPL Diagonal Call Spread Example
Using a current example with AAPL stock, let’s say that you have determined using your awesome technical analysis skills that AAPL will rise gradually for the next four months. You enter a diagonal call spread by buying a NOV 425 call for $300 and at the same time sell an OCT 450 call for $100. The net investment required to put on the spread is a debit of $200.
Just like a vertical spread, you have both limited upside profit potential and limited risk. The ideal situation is for the position would be that AAPL either remains flat and or closes in between the two strike prices (say $435). In this scenario, as soon as the near month 450 call expires worthless, the options trader can sell another call and repeat the entire process every month until expiration of the longer term call. Now you can see why it’s similar to a covered call strategy right?
On the downside, the maximum risk of the diagonal spread is limited to the initial debit it cost you to enter the position of $200. If AAPL all of a sudden starts falling hard, then your losses are capped at $200 and no more.
Although it’s a great strategy to add to your toolbox, it still is possible to lose money with a diagonal spreads if you are not somewhat correct on the underlying direction of the market. Hopefully you didn’t think it was a one way ticket to riches! As always, being proactive and using stop losses, risk management, and hedging greatly increase your odds of success.
A Quick Word On Volatility...
Lots of books and other websites talk about various trading strategies that are designed to benefit from changes in volatility. All of that is good and well, but sometimes as an investor in options, my interest is in gaining leverage and managing risk on a some-what directional basis.
There is no arguing that volatility needs to be watched closely, but when the premiums make the diagonal spread unattractive, it's a good idea to do your homework first before entering a position for the next couple months.