Understanding Long Diagonal Spreads

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The One-to-One Diagonal Spread
You create a diagonal spread when you buy and write options (calls or puts, but not both in the same spread) on the same stock with different strike prices and different expirations. As we will show in the examples in this report, diagonal spreads can be used as capital efficient covered call alternatives.

Why Diagonal?
A bit of folklore: Diagonal spreads are so named because on printed option pricing sheets, options are often listed with the different strike prices as the rows and the different expirations as the columns. Thus, you can draw a diagonal line between the option being bought and the option being sold.

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Using the same logic, basic bull and bear spreads, which involve buying and selling options with the same expiration but different strike prices, are often called "vertical" spreads (because you can draw a vertical line between the two options). Also, calendar spreads which involve buying and selling options with the same strike price but different expirations are often known as "horizontal" spreads (because you can draw a horizontal line between the two options). See Figure 1.



For most investors, a diagonal spread usually involves the purchase of a longer-term call (or put) and the sale of a shorter-term call (or put) with a different strike. Because the deltas of these options with different strikes are usually not the same, these diagonal spreads have some sensitivity to the underlying stock as with standard one-to-one bull and bear spreads.

Also, as with so-called long calendar spreads, these diagonal spreads tend to have a net time decay that is in the investor’s favor. This is because a shorter-term option is likely to lose time value faster than a longer-term one, if the stock stands still.

From an individual investor’s point of view, diagonal spreads can offer a very attractive return on capital with only limited risk. As long as the option purchased expires later than the one written, the margin requirements on diagonal spreads are the same as for one-toone bull and bear spreads.

That is: if you buy the more in-the-money call (or put) and sell the more out-of-the-money call (or put), you do not need to post a margin since the net premium you paid represents your maximum loss.

Alternatively, if you buy the lower premium out-of-the-money call (or put) and sell the higher premium in-the-money call (or put), you are required to post a margin equal to your maximum possible loss. This amount is the difference between the two strike prices times the number of underlying shares.

continued in "Part Two: A Covered Call Alternative..."

Posted By: Lawrence Cavanagh

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