Comparing Diagonal Spreads To Vertical Spreads For Directional Trades

by: Diagonal Trading

I trade options on near daily basis and am constantly skimming many options information sources, and it seems to me that one structure that I like to use gets far less discussion than many other strategies. I often use diagonal call spreads to make a bullish directional trades, but diagonal spread strategies don't seem to be discussed nearly as much as vertical or calendar spreads.

Out of curiosity, I searched Google for "vertical spread," "calendar spread," and "diagonal spread." Google finds about 187,000 search results for "calendar spread," about 112,000 for "vertical spread," and only about 35,000 for "diagonal spread." Since I find diagonal spreads offer advantages in many situations for medium-term directional trades, I thought I would highlight some of these advantages.

A Diagonal is Similar to Vertical Spread

A diagonal spread is one in which a trader buys one option and then sells a nearer-dated, further out of the money option against it. For example, today, with AAPL trading around $634, a trader with a bullish outlook on AAPL over the next three months could buy an AAPL Jan 650 call for about $34.05 and then sell a Nov 670 against the long for about $10.65 for a net debit of $23.40.

Like a vertical spread (in which both the long and short have the same expiration cycle), this structure is very similar to a covered call, except instead of buying stock and writing a call against the stock, the trader is buying the long call and writing the short call against it. On the flip side, a trader bearish on the underlying could use a put diagonal, buying a put and selling a nearer dated, further out of the money put against it.

Diagonals Spreads Are Defined-Risk Trade

I like diagonal spreads for directional trades for a few reasons. First, diagonals are a defined risk approach for making a directional trade in that the maximum risk is the amount of the net debit for the initial trade. So if the underlying goes against me, or doesn't move far enough in the right direction, I can't lose more than my initial investment. Secondly, the short option generates a credit that offsets the debit needed for the long position-which reduces initial investment and magnifies the return percentage on successful trades. Both diagonal and vertical spreads have these characteristics (although a vertical spread can be opened for a lower net debit than a diagonal spread with the same strikes).

Since it's likely that a trader will want to close or adjust a position before expiration as circumstances change after the trade is initiated. For medium term (say, six weeks or more for monthly expiration cycles, or two to four weeks for weekly cycles) directional trades, I find that diagonal spreads have advantages over verticals in many cases.

Diagonal Spreads Can Flip Theta from Negative to Positive

The main reason I often like diagonals over verticals is several characteristics of options prices that has to do with time decay. Diagonal spreads take advantage of the fact that nearer-dated options decay faster than further-dated options. An option's sensitivity to the passage of time is measured by theta. Simply buying a call has negative theta, meaning the value of the call decays with time.

A vertical spread, in which a further out of the money option of the same expiration is sold against the long, will have a theta that is less negative (versus a long option only) but theta will still be negative-meaning that the value of the spread will erode as time passes. However, a diagonal spread often can be constructed so that theta is positive, such that the short option is losing value faster than the long option, at least through the nearer expiration. In this case, the value of the spread would actually increase with the passage of time, even if the underlying doesn't move (until the short option expires). Not every diagonal spread has positive theta-in order to structure one with positive theta, the trader needs to select a short option with a strike and expiration cycle that aren't too far from the long option.

Avoiding Time Premium Working Against a Successful Trade

The other time decay characteristic this comes into play with directional spreads is the fact that at the money options have highest time premium, with time premium decreasing the further an option is from at the money-in either direction. The implication of this for vertical spreads is that as an underlying price approaches the short strike in a vertical spread (and becomes closer to at the money), the higher the time premium becomes. And, since the trader needs to buy back that short option to close the trade early, the increased time premium eats into the profitability of the trade.

Let's look at an example to illustrate this concept: if today (October 22), with AAPL at about $634, a trader believes AAPL might increase to $670 by January, he could buy a Jan 650/670 vertical call spread for a net debit of $8.30. If AAPL happened to jump to $670 in the next few weeks (e.g., November 19 for this example), the spread would be worth about $11.05-a nice profit to be sure, but not close to the maximum gain were the spread worth $20 as it would be if AAPL is trading over 670 at expiration. If the trade were closed at that point, the trader would leave nearly $9 of potential profit on the table. Or, the trader could hang on to the trade while the time premium erodes as expiration approaches. However, by doing so, the trader is risking that AAPL might drop in value again and profits would evaporate.

Alternatively, the trader could purchase a Jan 650/Nov 670 diagonal spread for $23.40, which if AAPL jumped to 670 by November 19 the long Jan 650 would be worth $45.70 and the short 670 would have expired worthless (or closed nearly worthless). At this point, the trade would have achieved virtually all of the $20 maximum profit. In this case, the trader has the option of closing the long Jan 650, or writing another short against it to lock in some profits. While this example shows a somewhat best case scenario, it does illustrate how an early closing of a successful vertical trade with the underlying near the upper strike sacrifices considerable profit in order to buy back the time premium in the short option.

Implied Volatility Considerations

Among other considerations, it is also critical to look at implied volatility (IV) when structuring a diagonal. I look to buy longer expirations when IV is low and sell longer when IV is high since premium is higher when IV is higher. If I am inclined to open a directional long trade when IV is low, I try and keep the short expiration closer in and may hold off on writing the short for a while until volatility comes up a bit. Conversely, if I am inclined to open a directional long trade when IV is elevated (though I tend to avoid these), I'd look to sell a short position with expiration further out, potentially in the same cycle as the long against which I am writing the short (i.e., a vertical spread).

In the End…

With a diagonal, after the nearer-dated short option expires, the trader can open another short against the long option to generate additional premium. Any option strategy depends on one's view of market conditions and risk tolerance, but diagonal spreads are worthy of consideration for risk-defined directional trades.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.