The diagonal spread is frequently used as a "roll" trade. In other words, the diagonal will often involve selling (buying) a short-dated option to close while buying (selling) a longer-dated option to open. Nevertheless, both legs of the trade can also be initiated simultaneously. In any case, the trade involves 2 options of the same type (put or call) but with differing expirations and strikes.
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 want to generate an ongoing income stream by selling calls against it. In some cases, the written calls will expire worthless. On the other hand, the stock will perform quite well and in order to keep it, he will have to cover the written call.
Let's say John own ABC and wrote a July 50 call against it. The stock has gained ground and is now sitting at 52 just a week before expiration. John does not want to be called out of the stock - perhaps he have a large potential tax gain that he wants to avoid, or perhaps he simply thinks the stock will continue a slow upward climb that is well suited to a continuous overwriting strategy.
So he looks for a higher-strike longer-dated call to write. He doesn’t want to go out too far and thus relinquish upside for an overly extended period, but he wants to take in enough premium to pay for most, if not all, of the call that must be bought back. (Note that he may always choose to buy back the call he has previously written, even if it is well out of the money. While he will incur a commission that seems unnecessary, the broker will likely require him to do that to avoid the capital charge associated with being short a naked call once he has written the longer-dated call).
It will cost $2.10 to buy back the July 50 call. Meanwhile, John can write an October 55 call and collect $2.05. Thus, before commissions, it will cost only a nickel to keep the stock. Meanwhile, the new trade will be a net winner unless the stock goes up more than 10% during the next 3 months. Since John is looking for slow growth - closer to 10% than 40% annualized - this trade makes sense.
With most multi-legged option trades, a trader will always know ahead of time whether the strategy he wants to put on is a credit or debit trade. This is not the case with diagonal spreads. Each trade must be reviewed independently, because a trader cannot say ahead of time whether the strike price or time difference will have a larger effect on the options' prices. Thus it is nonsensical to speak generically about "diagonal credit spreads" or "diagonal debit spreads." At the same time, it is especially important to take particular care in placing orders and making sure the broker is aware of a trader’s intentions.
When both legs of the diagonal are being initiated at the same time, the thought process is somewhat (though not completely) different. If a trader is longer-term bullish but short-term neutral on a stock, the diagonal spread (selling a short-dated call and buying a longer-dated one with a higher strike) can be a very effective way of leveraging this view.
However, 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 2 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 to expiration.
Example 1:
XYZ Corp. is trading at 49. Jim doesn’t expect the stock to do much during the next month, but earnings are coming out in 2 months and he thinks the stock could really run. He sells a 1-month 50-strike call and buys a 3-month 55-strike call. It turns out that by selling a lower strike than he is buying, he is able to buy the extra 2 months of option life and take in a small credit. He receives $1.35 for the 1-month 50-strike call while he pays $1.15 for the 3-month 55-strike call, taking in $0.20 before commissions.
If XYZ is trading at $49.75 in a month, the first option (the sold option) expires worthless. The remaining call still has 2 months of life remaining and is trading at $0.85. This is on a position that Jim was paid $0.20 to initiate a month earlier. Should he sell the remaining option, his pre-commission profit would be $1.05. Since the capital required for this trade would be the difference between the 2 strike prices, his return would be $1.05/5, or 21%.
Notice that if Jim had simply bought the 55-strike call, he would have already lost more than a quarter of the option value (from $1.15 to $0.85). Using this strategy helps pinpoint the investment to a trader’s anticipated time horizon and thus avoid spending premium he doesn’t want to pay.
Of course, that's what happens when a trader is right. Now consider a worst-case scenario. Before the first option expires, the company comes out and pre-announces that earnings are going to be far better than anyone was anticipating. Analysts rush to upgrade the stock and it trades up to 57.
Now the trader is essentially forced to unwind your trade, because the sold calls are almost certain to be exercised. Jim would thus end up owning a 55-strike call against being short a $57 stock. This is equivalent to owning a slightly out-of-the-money put.
If the trader unwinds the trade now, he has to pay $7.20 for the call he is short, while receiving $4.30 for the call he is selling. This net $2.90 outflow leads to an ultimate loss on the trade of $2.70, or more than half the capital risked.
While this is not a pleasant outcome, it's probably better to close the trade than to hold on to a trade he never wanted. Unless the stock trades sharply below 55 before the long option expires, the trader is likely to lose the $2.30 in time value the option currently has ($4.30 market value less $2 intrinsic value, 57-55).
Because of the possibility of such an outcome, a trader should be careful when using diagonal spreads.
