The diagonal spread is an interesting trade. At first glance, it appears more complex even than a calendar spread. If you've put off trading diagonal spreads for this reason, I hope I can help bring some clarity.
|Construction||Made up of 1 long option and one short option with different months AND different strike prices. The short strike will be nearer month while the long strike price will be a farther out month. Usually the long strike in the father out month will be deeper in the money|
|Example||Long October 34 call + Short August 38 call (Bullish diagonal)
Long October 38 put + Short August 34 put (Bearish diagonal)
|Max Gain||Difficult to determine. There is a large up side potential under the right conditions.|
|Max Loss||Initial debit|
This diagonal spread strategy shares a lot of characteristics with the calendar spread. In that respect, it takes advantage of the fact that the option in the front month decays at a faster rate then the option in the back month. On top of that, there is the additional vertical spread component that can add potential profitability of the spread.
What I mean by the vertical spread component is the difference in strike prices. As an example, lets say I buy an October $38 call and sell an August $42 call. With the underlying trading right at $40, I already have $2 of intrinsic value attached to the long $38 call. If the underlying stock or index moves up through the short strike, I will make at least $4 per contract on the trade. More than likely my cost for this trade will be less than $4. This is very similar to the characteristic of a long vertical call spread isn't it.
What about the calendar spread component? If I have a short $42 call and I'm approaching its expiration, I can roll this position to the next month with the same strike, lower strike or higher strike. When I roll from the to the next month, I will most likely receive an additional credit that will lower my overall cost basis. If the stock has moved strongly up and I'm feeling particularly bullish, I may choose to sell a strike price farther away. While I may receive less of a credit up front for this, I can potentially make more on the move if the underlying continues to move up through my short strike due to the wider price spread between short and long strikes.
Another way I tend to think of diagonal call spreads is like a covered call except instead of owning the stock, I own the right to purchase the stock (by purchasing a long call in the money and farther out in time). Then, much like a covered call, I sell a short call in the current month and continue to do so each month as the stock or index moves.
Because a diagonal spread shares many characteristics of the calendar spread, it also benefits from an increase in volatility. This makes it an interesting potential trade when volatility is running a the lower end of its range.
I tend to trade the diagonal spread in times when there is a clear trend established, either bullish or bearish. If I'm less certain about the trend or the trend appears more neutral, then another strategy is probably better.
For the remainder of this discussion, I'm going to use the chart of the QQQQ, an ETF that tracks the Nasdaq 100 index.
In this example QQQQ has been in an uptrend since early March with a pause in the June/July timeframe. Now, with the breakout over resistance, this may be a good opportunity to take a bullish diagonal spread trade.
Additional Diagonal Spread Links
While it is possible to trade this strategy on any optionable stock, I prefer to trade on index tracking ETFs such as the QQQQ, SPY, DIA, IWM, etc. The main reason for this is that they offer $1 strike increments. This gives me more control over where I chose my long and short strike positions. In addition, the index ETFs tend to trade higher volumes on the options, which can offer me a better fill price getting in and out of the trade.
Beyond that, if I'm going to trade this diagonal spread strategy, I want to use a stock or ETF that is in a trend. I'll trade call diagonals on a bullish trend and put diagonals on a bearish trend.
The entry of a diagonal spread should be similar to that of any bullish or bearish trade. I may choose to enter a bullish diagonal spread on a bounce off of support or break of resistance (as in the case of the QQQQ above). On a bearish entry, I would look to enter on a bounce off resistance or a break of support.
When I'm researching a potential diagonal spread, there are several factors I consider.
One other aspect to look at in general any time I'm considering a particular option is the open interest. Higher open interest will generally offer me a better fill price. The reason is that there is more volume typically trading back and forth and the market maker is more likely to move somewhat off his bid/ask to give me a fill. I generally look for the short strike in the nearer month to have open interest of several thousand while the farther out long strike will likely not be as high (most options are traded in the front two months rather than farther out). I'll look for open interest in the hundreds.