A diagonal spread trade has two option legs on the same underlying stock (or ETF) in different expiration months and at different strikes. These trades can be done using calls, which is a neutral-to-bullish trade, or using puts, which is a bearish-to-neutral trade.
InvestorsObserver analysts employ the bullish version of a diagonal spread in situations similar to those that are right for covered calls, that is when we are mildly bullish on the underlying stock. The way we set up our trades, they are very similar to covered calls, but require much less capital per share and therefore have the potential for higher profits. In fact, sometimes we call these trades simulated covered calls.
Instead of buying the stock and selling a call, our analysts identify positions where we can purchase a call in place of the stock holdings. In some cases, these long-term calls are known as LEAPS, which stands for Long-Term Equity AnticiPation Security. Just like the stock in a covered call, we buy these longer-term calls to cover our sold call in case we are assigned and need to deliver stock. Because of that, we need to purchase one call contract for every option contract we sell.
In the case of a bearish diagonal, the mechanics of the trade are the same, but we use puts instead of calls, and the goal is for the stock to be below the strike price of our sold put.
These trades are debit spreads because we have to pay to acquire the options used in the trade. Our total risk is limited to the amount paid to open the trade. For a diagonal trade to work, the debit you pay to enter must be less than the difference in strike prices. That way, if our sold option is assigned, which is our final goal, then we can exercise our bought option and be assured of a profit.
Diagonal trades are typically profitable any time the sold option is in-the-money. Remember that means if the underlying stock is above the strike price of a call, or below the strike price of a put. If our sold options expire in-the-money, we are assured of making a profit by exercising our bought options. However, in almost all cases, you can exit a diagonal spread early by selling your bought option and buying the sold option for a net credit equal to, or slightly less than, the difference in strike prices. This will unwind the position completely and as long as we get a larger credit than our original debit, we will make a profit on the trade.
If the sold option expires out-of-the-money, we will still hold our bought option. At this point, we may choose to sell another option to bring in additional credit against the bought option, or we may be able to exit the long-term position for a profit by capitalizing on the remaining time value.
Unlike a covered call, since our covering position is an option itself, that means it has an expiration date of its own. Because of this, there is a little extra inherent risk for diagonal trades compared to covered calls. With a covered call, if the stock hits a rough patch, we can hold it indefinitely and wait for a comeback. However, if our bought options expire worthless, that is the end of the diagonal position and we could take a total loss.
One more dissimilarity between covered calls and diagonal spreads is the dividend situation. Since we do not hold the underlying stock, we are not entitled to a dividend. In some cases, we may even be assigned on our sold calls (there is no dividend liability when dealing with puts) just before a stock’s ex-dividend date. In these cases, the potential exists for us to actually owe the dividend payment if we are short the stock when it goes ex-dividend.