Compared to covered calls and other basic options strategies, diagonal spreads don’t get a lot of love. But not only are they relatively straightforward, they’re also flexible and versatile. Here’s the story.
When a new(ish) option trader graduates from the basic strategies—covered calls and vertical spreads, for example—to more advanced multi-leg spreads, it can be a little intimidating at first. And diagonal spreads are no exception. But once you understand how these options spreads are put together, they may not seem so tricky. And as for being useful, diagonals could be your next step into options trading if you’ve ever sold a covered call.
Intrigued? Here’s the story of diagonal spreads.
Note: there are two distinct conversations—chapters, if you will. The first is about diagonal spreads as a strategy—how and why you might put on a diagonal. And then there’s the diagonal spread as a trade, and specifically, why they’re a popular choice when rolling a single-leg option.
Each diagonal spread is made up of a long and a short option—both calls or both puts—with different expiration dates and different strike prices. Think of it as the combination of a calendar spread (same strike; different expiration date) and a vertical spread (same expiration; different strike).
The term “diagonal” comes from looking at options on a typical option chain, where the short option and long option are oriented sort of diagonally from each other. A diagonal with two calls is a call diagonal spread (see figure 1). A put diagonal spread has two puts.
Whether a diagonal is “long” or “short” depends on the deferred leg. A long diagonal is long the deferred month and short the near month. A short diagonal is short the deferred expiration date.
Let’s start by taking apart a long diagonal. Specifically, we’ll compare a long diagonal to a long calendar and a short vertical.
Imagine you’re short the June 135 strike on our old favorite, XYZ. A short option involves positive time decay, or theta, which means you make money from the passage of time. To preserve the positive time decay of the short option, you could buy an option that’s slightly further out of the money (OTM) and in the same expiration. That creates a short vertical spread. The further OTM option is cheaper than the close-to-the-money short option. That’s fine, but if your strategy is to short options that are closer to expiration month after month, you’re going to have to buy that option as a hedge month after month. That could end up being a lot of transactions, each of which could incur some costs.
FIGURE 1: CALL DIAGONAL PROFIT & LOSS. The shape of this graph will vary depending on where you place your short and long strikes. But the curve represents a short, at-the-money, short-term call along with a further out-of-the-money, longer-term call. For illustrative purposes only.
As an alternative, you could buy an option at the same strike price as the short option, but in a deferred expiration—say, a September 110—to create a long calendar spread. That hedges the short option, and if you buy an option with an expiration that’s a few months further out than the expiration of the short option, you don’t have to keep buying the hedge. But the further-expiration option is more expensive than the near-expiration option. And it’s susceptible to a drop in implied volatility. Both those factors can put a dent in your positive time decay.
A third strategy is putting that long option at a further OTM strike price and a further expiration. This does a couple things:
You’ve just created a long diagonal options spread.
Most stock investors look for long stock exposure. But long stock can tie up a lot of capital and expose you to risk if the stock moves lower. Because of that, some stock investors buy in-the-money call options in a further expiration instead of buying stock. The calls are less expensive than the stock, and the risk is limited to the price of the call. It’s a way to get long stock exposure (for a limited time).
A short diagonal—combining the long call with a short OTM call in a nearer-term expiration—is similar in strategy and exposure to a covered call. The position targets positive cash flow in return for an upside limit on the return potential. (Here’s a refresher on covered calls.)
Just as with a covered call, you can sell the out-of-the-money options in each new expiration cycle in the diagonal to keep that cash flow coming. Think of it as “rolling” the short options from one expiration to another.
Fairly intuitive, right? Of course, putting on and babysitting diagonals might not be your cup of tea. Like all options spreads, they’re not for everyone.
But even if you never venture beyond the covered call or protective put, you may find it useful to familiarize yourself with placing a diagonal spread trade.
Why? Because options expire. And depending on your strategy, it might make more sense to roll a position “down and out” or “up and out.”
Suppose you’re long XYZ, and with the stock at $130, you sold the 140-strike call against it. Now suppose expiration is approaching and XYZ is trading at $137. Do you wait until expiration and then sell a fresh call? If there’s little or no premium left in the 140s, it might be time to buy back your short call.
Considering the recent rally, does it make sense to stick with the 140 strike? If your typical strategy is to sell a call that’s 7% to 10% OTM, probably not. You might choose the 145 or 150 strike.
You could do those two trades individually, or price them up as—you guessed it—a diagonal spread (see figure 2).
Now that you’ve read the diagonal tale, are you convinced that the story is simpler than you may have thought? Hopefully so. Now that you know how diagonals are put together, you can analyze the position to see where it could lose money. And if you’re ready to place a trade, you’ll know how to enter the diagonal order as a single spread.
While options are definitely not for everyone, if you believe options trading fits with your risk tolerance and overall investing strategy, TD Ameritrade can help you pursue your options trading strategies with powerful trading platforms, idea generation resources, and the support you need.
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