Diagonal Spreads
Basics
You create a Diagonal Spread by buying a long-term option while simultaneously selling a shorter-term option with a different strike price.
There is a maximum profit potential, like a vertical spread
There is also a maximum loss potential
You can trade the same diagonal spread for multiple months in a row
There are NO margin requirements
You must have Level 3 options trading authority
The difference between diagonal spreads and vertical spreads is that the two trades involved in the Diagonal have different expiration dates
Diagonals are also called Calendar Spreads or Time Spreads too
Diagonal Spreads allow you to offsetting the costs of entering a long option position. But by doing so, you put a cap on the max gain potential
If the spread you are considering will consist of the major % of the existing open interest, the market may move to meet the order and the spread could be entered at an unfavorable price
Always check the open interest and make sure the number of contracts you want to play does not exceed 1-2% of the open interest
Open interest of 100 contracts or more is desirable
Diagonal Bull Calls
Diagonal Bull Spread- Stock should be neutral to up trending
You will get the max gains if the stock is trending up
Use in the same conditions that you would play a covered call or a long call.
If the short call expires worthless, you can generate monthly income by selling another call for the next month and the next, and so on.
Advantage of a Diagonal Spread over a covered call: The Diagonal Bull Spread is much cheaper to get into.
The long side will cover the short side if the contract is assigned unexpectedly.
Conservative investors should buy In The Money Options
The long call should be 4-6 months away
The short call should be 20-40 days till expiration
How to play a Diagonal Bull Call spread
1. Buy a Long-Term option on a Bullish stock at a Strike price below the current trading price of the stock.
2. Sell a shorter-term call option that is higher than the stike price of the call you purchased.
3. When you purchase the option lower than the Share price, this allows you to buy the stock from someone else at a lower price as long as the stock remains above the strike price.
4. You achieve max profits if the stock closes above the higher strike price on expiration date
Example
1. Sept. 5 trade date
2. Stock =31.00
3. Feb $25 call is bought for -$7.00
4. Sept $35 call is sold for +.50
5. Net Debit= - $6.50
6. Maximum Profit potential: = Difference in the Strike Prices less the net Debit
7. $35.00- $25.00= $10.00 // $10.00-$6.50=$3.50
8. Max Profit=$3.50/share or $350.00/contract
9. Max Loss= Net Debit= $6.50/share or $650.00/contract
10. Assume the stock drops to $20.00 tomorrow and remains below $25.00 through Feb = You would get the max loss
11. Lets assume the stock climbs quickly to 38.75 on day 10 with a week left until expiration
12. You buy back the $35 call for -2.00
13. You sell the Feb $25 call for +11.90
14. 11.90 -6.50 - 2.00= $3.40 Profit
Options Levels
L1=Covered Calls
L2=Long calls and Puts
L3 Spreads
L4 Short Calls and Puts
L5 Short Index Options
