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Thus far in our options education series, we’ve examined simple bull and bear spreads – often referred to as “vertical spreads” because they involve the same underlying security with same expiry but different strike prices. We’ve also looked at calendar spreads – also called “horizontal spreads” because they pair the same security with the same strike but different expiries.
Today we’re going to look at the third (and last) type of spread, called a “diagonal spread” because it uses the same security, but with different strike prices and different expiries.
The rationale for the diagonal spread strategy is most often to capitalize on a situation where a sideways move is expected in the near term for the underlying security, followed by an abrupt spike at a later date. The trade can be geared for any combination of sideways-up or sideways-down movements in the underlying security, but for the sake of illustration, we’ll focus on the former.
Let’s use an example.
Let’s imagine Apple (NASDAQ:AAPL) has just had a good run and is looking toppy. You figure the stock will likely go to sleep until the company’s next earnings release, after which you expect the rise to continue.
Here’s six months worth of chart for the company:
As you can see, the run up through November 2014 was sizable (red lines). But on Dec. 8 (blue circle), with the stock at 112 and beginning to tail off, you buy the February 110 call, slightly in the money, for $8.40. Your choice of that expiry is based on it being situated on the far side of the next earnings report, after which you expect an announcement that will send the stock higher and your call that much deeper into the money.
In the meantime, though, you seek to take advantage of the meandering sideways move you expect to transpire until then. So you look at the near-term options chain and see the January 118 strike is selling for $2.60 (black line). You don’t expect the stock to retrace to that level – very close to the most recent highs – by expiry, so you sell the option, reduce your cost for the in-the-money call to just $5.80, and wait.
And you score big!
The company’s shares bide their time with a sideways slide that puts your short call out of the money by expiry, offering you the full premium (and a cheaper in-the-money call) as you wait for the next round of earnings data.
Earnings are announced early in February and the long option flies. It expires at $128.30 (red circle), giving you a total profit of $1,250 ([$18.30 – $5.80] x 100). Remember that one options contract equals 100 shares of stock.
Variations Abound
Technically, the above trade is referred to as a “diagonal bull call spread,” but a closer look reveals that the trade works on the selfsame principle as any covered call initiative.
Indeed, many traders employ the diagonal spread strategy using a longer-dated at-the-money or in-the-money LEAPS call as a substitute for holding the company’s shares. That strategy lets them write premium (sell calls) against the long option on a regular monthly basis, thereby reducing the overall cost of the trade and increasing its profit potential. For more information on this strategy, see Andy Crowder’s article about “poor man’s covered calls.”
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