In today’s option trading blog I will dicsuss diagonal spreads. A diagonal spread combines an equal number of longer term options and shorter term options with different strike prices. The term actually comes from the way the options were listed in the newspaper. If you connected the two strikes, a diagonal line would run across the page. In a traditional sense, you are long the longer term option (the anchor leg of the spread) and it is closer to the money. By rule and regulation any other combination would involve considerable margin.

For instance, if you were long a May 65 call and short an August 80 call, the August 80 call would be considered naked. That would require the highest level of option trading approval from your brokerage firm and considerable margin would be posted. If you were short the May 65 calls and long the August 80 calls, the position is covered, but you would have to satisfy the 15 point margin requirement (difference between the strike prices).

Let’s take a final look at the PCAR trade I have referenced during the last two articles. At one point in the trade, I was long the August 65 calls and short the June 80 calls. That is a traditional diagonal spread and it is the type I will be discussing.

From my perspective, the intent of the diagonal is to take advantage of front month time premium decay while still giving the trade some room to move. Using a bullish example, it would be similar to a covered call position where you are long the stock and short an at-the-money (ATM) or out-of-the-money (OTM) option. In order to achieve this, the back month option needs to be deep in-the-money.

Given that there is more time until expiration on the anchor leg of the spread, the option will carry more time premium. In order for me to reduce that I have to go further and further ITM to find an option that is trading close to intrinsic value. The more volatile the stock, the richer the premiums, the deeper you must go for the long leg of the trade. Again, with reference to the PCAR trade, I bought the August 65 calls ($9.80) that were two strikes ITM and I still had to pay $2.80 in time premium (stock was $72). The disadvantage was that even with an ITM option, I still had to pay time premium. The advantage was that the front month OTM options that I might sell, also carried a lot of premium.

In the end, this strategy if properly constructed will act like a covered call where you are long stock and short a call option. However, there are a few distinct advantages to the diagonal spread.

1. You don’t have to put up the stock margin, you just have to pay for the spread.
2. The risk on the position is limited to the price paid for the spread (not the price of the underlying stock less the call credit).
3. The ITM option will eventually implode with time premium if the position moves against you. To learn more about this concept read Buying In-the-Money Options – A Hidden Benefit.

Keep in mind that you are not entitled to dividends with this strategy and that the bid/ask spread of the ITM option will probably be much wider than the underlying stock. Slippage and dividends are two possible limitations.

In the next article, I will write about how I trade diagonal spreads.

If you’ve tried one, share your experience and comment.

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