A Diagonal Spread is an option spread where the trader buys a longer-term option and sells a near-term option. The inverse could also be considered a diagonal spread, however, the longer-term option is margined as naked short. That means the margin requirement is higher and the account needs to be approved for naked option writing.
When you buy a longer-term option, the shorter-term option is considered “covered,” and the margin requirement is much smaller. An example would be to buy an October $50 call option and to sell an August $60 call option. The idea is to take advantage of time premium decay and to defray the cost of the longer-term option. Option investors might consider buying a LEAP option and selling near-term options against. I do have a rule of thumb for these option spreads. The debit that I pay for the spread always has to be less than the difference in the strike prices. This means that if the stock explodes higher, in a worst-case scenario, I will still make money on the trade. If the debit paid for the option spread is greater than the difference in the strike prices, the trade could lose money even though you had the direction picked correctly.
In the previous example, if the stock moved to $80 and you paid $11.00 for the diagonal spread, the option trade would lose money. Both the October 50 call and the August 60 call will be trading at parity and the spread will be trading for $10.00. Given that you paid $11.00, you lose $1.00. There is not a worse feeling than losing money on an option trade when you got the direction right. An alternative diagonal spread is to buy a long-term out of the money option and to sell a near term closer to the money option. The idea is to sell closer to the money option premium against the long-term leg month after month. The problem with this diagonal spread option strategy is that the stock can move in the direction of your bias. If it does, it could be so far out of the money that you can’t collect much premium when you go to sell future stock options against the position. For instance, if you are bearish on a stock that is trading at $85, you might sell the August $90 call options and buy the October $95 call options. When the August $90 call options expire, you would plan to sell the September $90 call options against the October $95 calls. This is a good strategy, but if the stock drops to $70, the stock options are so far out of the money that you won’t collect much option premium. If you sell closer to the money options, your margin requirement will be high because your long option is so far out of the money.
