How I Trade Diagonal Spreads!

For purposes of this option trading blog, I will refer to diagonal spreads in the traditional sense. The position consists of an equal number of contracts where the long leg of the spread (the anchor) is closer to the money and it is further out in time than the short option. Let’s look at a bullish position. Let’s say that I like a stock that is trading at $52.50 and I think it will grind $6 higher for the next 3 months. I decide to buy an October 50 call for $5.00. Let’s also assume that there are 3 weeks left until August expiration and the August 55 calls are trading for $.80. If I feel that the stock is on a slow and steady path, I rationalize that it may not reach $55 in 3 weeks. So, I decide to sell the calls and bring in some premium. At expiration the stock can actually rally to $55.80 and I’m no worse off. In that case, I can buy in the August 55 calls back for $.80 and sell the October 50 calls for a nice profit. The sale of the premium helps offset the time premium decay of the October options and it provides some protection. The key is to make sure the diagonal can’t lose money if the stock really takes off. This can happen if the debit for the diagonal is greater than the difference in the strike prices. For example, let’s say that I bought a January 50 call for $8 and sold the August 55 for $.80. The debit for the spread is $7.20. If the stock goes to $65, it is likely both options will be trading near parity ($16 and $10) and the trade will lose money even though I was right on the direction of the stock. If you were long term bullish on a stock and you wanted to take a position, you might consider buying a long term option (maybe a LEAP). You might also want to generate some income while you wait for the stock to move up. You take advantage of accelerated time premium decay and sell an out-of-the-money (OTM) near term option against it. This is another example of a diagonal spread. There are people who will convince you it is similar to a covered call on a stock that does not pay a dividend. There are some key differences. The LEAP carries premium, it does not have a delta of 1 (like the stock does) and the bid/ask spread is wider on the option than the stock. You may also run the risk associated with a diagonal where the debit for the spread is greater than the difference in the strikes. One final note, if the stock moves through the short option on a covered call position, you simply let the stock get called away and you are flat. In a LEAP diagonal, you have to buy-in the shares of stock that you are short from assignment and sell the LEAP. You do this because there is premium in the LEAP and you do not want to exercise it. There are more transactions involved and hence more slippage. I have NOT found LEAP diagonals to be an effective strategy although many seminar companies “spin” it to sound good. To buy an in-the-money (ITM) LEAP option that trades at parity, you have to go so far ITM that you will almost put up as much money as you would to buy the stock on margin. One could argue that the risk is limited on a LEAP diagonal. While that may be true, if you are buying a LEAP you are putting up a lot of money too. Hopefully your long term investments are not speculative stocks that have the possibility of going to zero. At some point, weather you are long the stock or the LEAP, you have to stop out the losing trade. Consequently, the “limited risk” argument doesn’t resonate with me. If you like to trade diagonals, share your experiences.