Options Spreads IV - Long Diagonal Spreads
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.
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. 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. (See our report, "Options Spreads I: Basic Bull and Bear Spreads - Ot051017.Pdf.) 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. (See "Calendar Spread Dynamics," Ot041108.Pdf)
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.
A Covered Call Alternative
In Graph 1, we show an example of a diagonal spread used as an alternative for a covered call. With the stock price at $91.26, we have bought the Aetna January 2007 $40 call for $53.40 (instead of the stock) and written the January 2006 $90 call for $4.90. For a spread consisting of one option on each side, the total net debit comes to $4,850, versus $8,636 for the covered call ($9,126 to buy the stock minus $490 for writing the call). We selected the call to write from the option screener, looking for rank 1 covered call expiring in January 2006. We then looked for a longer-term call to buy on this same stock that was trading close to its tangible value.
The graph above shows how this position would perform on three different dates over a plus or minus 25% price range. These are (1) November 16, 2005, the date the position was established, (2) December 19, 2005, halfway to the January 2006 expiration, and (3) January 21, 2006, which is the expiration date of the short call. Note that this position has many similarities to a covered call position, but there are some important differences as well.
One difference is that because the longer-term option does lose some value because of time decay, the maximum profit can be less than with a covered call. Also, because the longer-term option will tend to lose time value as it moves more deeply into-the-money, diagonal spreads can see a declining profit if the stock rises far enough. In fact, if the longer-term option has more time premium than the shorter-term one (not the case in this example), the diagonal spread can actually lose money on a very big gain in the stock.
In Graph 2, we show an example of the same spread, but this time using puts instead of calls. Here we have written the Aetna January 2006 $90 put for $3.20 and hedged ourselves by buying the January 2007 put for $0.15 for a net credit of premium of $3.05 (or $305 on a spread with one option on each side). As with the vertical credit spread, we are required to post an amount equal to the difference between the two strikes - $50 (or $5,000 for spread with one option on each side).
In this example, the put spread offers a somewhat better return, with a maximum profit of $308 versus $233 for the call spread. Also, it should be noted that with the put spread, the investor may be allowed to apply other capital assets (stocks, bonds or mutual funds) towards meeting this margin requirement.
Testing Diagonal Spreads with Whatifi.Xls
Diagonal spreads can be tricky, so you need to fully understand how they are likely to behave before using them. We recommend that you use our template Whatifi.Xls file to help you visualize how these spreads are likely to work. See "Introducing Whatifi3.Xls (Ot050214.Pdf) in Options Reports.
Subscribers may also want to read our recent reports, "Credit Spreads as 'Naked' Write Alternatives," (Ot051107.Pdf) and "Capital Efficient Covered Call Alternatives," (Ot040621.Pdf).