The Option Coach: Diagonal Spread

              

Welcome back to another in a series of articles that examines the thought process behind a variety of option strategies using stock, index, and/or exchange-traded fund (ETF) options. One interesting trading strategy that we haven't covered in a while is the diagonal spread. This column will examine a diagonal spread, the pros and cons of putting on a diagonal spread, and the profit and loss potential of this position. So, let's jump into this interesting strategy.

The diagonal spread involves two options of the same type (put or call), but with differing expirations and strikes. It is frequently used as a "roll" trade. In other words, the diagonal will often involve selling to close a shorter-dated option position, while simultaneously buying to open a longer-dated option position on the same underlying equity. This tactic is often used to extend the lifespan of a winning option position to a later expiration date.

Nevertheless, both legs of the trade can be initiated simultaneously. Typically, as the shorter-term option expires, the trader will sell a back-month, near-the-money option, changing the diagonal spread into a regular credit spread.

From the perspective of a roll, a common example of a diagonal is as part of a long-term overwriting strategy. This is when a trader owns a stock that he wants to keep, but wants to generate an ongoing income stream by selling calls against it. In some cases, the written calls will expire worthless. On the other hand, if the stock performs well, he will have to sell to close the written call in order to keep the underlying equity in his portfolio.

If a trader is longer-term bearish/bullish but short-term neutral on a stock, the diagonal spread can be a very effective way of leveraging this view.

A diagonal spread is also another way to take advantage of an unwinding of high implied volatility. If the stock remains relatively unchanged, the implied volatility of the short-term option will unwind faster than that of the longer-term option, allowing the trader to lock in a profit should he close out the position ahead of expiration.

This is a complicated strategy reserved for only veteran traders, as it requires that a trader be precise in both his prediction of the stock movement as well as the timing of the move.

Stock and Option Selection

A diagonal spread is a relatively neutral strategy, so the trader is typically expecting the shares of the underlying stock to move very little during the next couple of months. Traders may wish to use this strategy on range-bound equities with defined levels of support and resistance. It is also important to make sure that the security does not have any upcoming events such as earnings, which could cause an unexpectedly sharp move in the shares.

Traders should also be on the lookout for stocks that have abnormally high implied volatility readings for no apparent reason. An unwinding of these implieds will push the premium of the sold option lower.

Traders will typically focus on a short-term, front-month option to sell to take advantage of the waning implied volatility and the increased effects of time decay. At the same time, the trader will buy a back-month option (usually one month later than the front-month option, though longer time frames can also be used).

Let's Look at an Example

Today's theoretical trader has turned his attention to the shares of General Mills Inc. (GIS: sentiment, chart, options) for his diagonal spread. The stock has bounced from its March low of $46.37, but has stalled at staunch resistance at the $67 level, which has capped the shares during the past several sessions. However, potential support is rising into the region in the form of the stock's 10-week moving average.

Meanwhile, optimism is building toward the security. The International Securities Exchange (ISE) and the Chicago Board Options Exchange (CBOE) have reported an increase in call trading. The stock's ISE/CBOE 10-day call/put volume ratio checks in at 10.91, which is higher than 96% of all those taken during the past year. This lofty reading indicates that optimism is on the rise toward the shares.

Wall Street also remains smitten with the food company, as the stock has earned 11 "buys" out of a total of 14 analyst rankings. This leaves the security vulnerable to potential downgrades, should the stock fail to finally break through technical resistance.

With the stock looking to remain trapped below key resistance and November options set to expire in a few weeks, our trader has opted to sell the out-of-the-money November 70 call, which is currently bid at $0.10, and buy the out-of-the-money December 75 call, which is currently asked at $0.10. The end result is breakeven on the position.

The expectation is that the shares of GIS will remain below the sold 70 strike until November options expire.

However, the trader's not done with this position when the November option expires, since he will still have open the December 75 call. Assuming that the stock remains below the 70 strike, the trader will then sell to open a December 70 call, collecting a second credit and turning this position into a normal credit spread. And, as we know, the goal in a credit spread is for both of the options to expire worthless so that the trader can retain the entire premium.

Margin Requirement

Assuming that the entire position is closed out when the front-month option expires, the margin requirement for a diagonal spread is the difference between the two strikes minus the credit received, if any. In this case, the margin requirement is $500: [(75 - 70) - 0] x 100.

If the position is left open after the front-month option expires, the margin requirement changes to match the next trading strategy that the trader implements, whether it's simply a long call, a credit spread, or a debit spread.

Implied Volatility

Ideally, a trader is looking for options that initially have high implied volatility readings on a relative basis, as an unwinding of this premium will benefit the short-term option.

Profit and Loss

The maximum potential profit in this example is limited to the net credit received for the sold call at the lower strike, minus the premium paid for the call at the higher strike. Unfortunately, you cannot precisely calculate the potential profit at initiation, because it depends on the premium received for the sale of the second call at a later date.

If established for a net credit, the maximum potential loss for the position is limited to the difference between the two strikes minus the credit received, which is also the margin requirement on the position.

If established for a net debit, the maximum potential loss for the position is limited to the difference between the two strikes plus the net debit paid.

Overview

To make this strategy work in his favor, one thing that a trader must keep in mind is that he must be right about his expectations for a stock's movement over a significant period of time.

Furthermore, the trader must be willing to accept the fact that if he is right about direction but wrong about timing, he will end up losing roughly the difference between the two strikes. This is because with diagonals, as with their cousin - the calendar spread - a big move before the first expiration benefits the trader who bought the shorter-dated option and sold the option with more time until expiration. On the other hand, no movement in the stock will benefit a trader who sold the shorter-dated option and bought the option with more time until expiration.

In case you've missed some of the other strategies covered in this column, here is a quick list of links to some of the other topics we have covered here.