The diagonal spread offers a great compromise between the vertical spread and the horizontal spread. It incorporates the best features of each while avoiding some of the drawbacks of each.
Let's briefly review the vertical and horizontal spreads including the shortcoming of each. For the discussion here, we will consider only debit spreads.
You buy a Call (Put) that has a delta of magnitude .45 to .65. Then you sell a Call (Put) with a higher (lower) strike price. Both Calls (Puts) will have the same expiration date. Ideally, you want the sale price of the short option to lower the cost of the long option by at least 30%.
The Vertical Spread achieves its maximum return at expiration when the price of the underlying stock has moved beyond the strike price of the short option.
Shortcomings of the Vertical Spread: Must wait until the expiration of both options to achieve the best profit. Profit is limited to the difference between the two strike prices less the net cost of the spread.
HORIZONTAL SPREAD (also called a calendar spread or time spread)
You buy a Call (Put) with a strike price that is near the current stock price. The expiration date of the long Call (Put) is typically 4-8 weeks in the future. Then you sell a Call (Put) with the same strike price and a closer expiration date. Ideally, you want the sale price of the short option to lower the cost basis by at least 30%.
The Horizontal Spread achieves its maximum return if the stock price is very near the common strike price when the short Call (Put) expires.
Shortcomings of the Horizontal Spread: The stock price must be very near the common strike price at expiration in order to have a reasonable profit. If the stock price is even modestly removed (up or down) from the strike price, the spread is unlikely to produce a profit. Must be wary of any event (earnings report, etc) that might cause a large move in the stock price prior to the near term expiration date.
The compromise between the Vertical Spread and the Horizontal Spread. You buy a Call (Put) that has a delta of magnitude .45 to .65. Then you sell a Call (Put) with a higher (lower) strike price that has a closer expiration date.
The Diagonal Spread has the advantage of directional movement offered by the Vertical Spread, while also providing the relatively quick expiration of the short option offered by the Horizontal Spread. If weekly options are available, there is substantial flexibility in selecting the time frame over which the trade can be maintained.
ILLUSTRATION USING PROCTER & GAMBLE (NYSE:PG)
To illustrate the diagonal trade, let's consider a current trade on a popular Dow stock, Procter & Gamble Co (PG).
Example Trade: In early June, PG was trading at $78 after a modest pullback. With an earnings report due on August 1, it was felt that PG would likely be moving up over the next six weeks.
Trade: One July (monthly) 75 call was purchased for $3.60 and one June (monthly) 80 call was sold for $.35. Net cost of the trade was $3.25.
Comment: Note that the premium received from the sale of June 80 call reduced the cost basis by about 10%, which is significantly less that what would be expected in a vertical or horizontal spread. The diagonal spread is typically more expensive than a vertical or horizontal spread, but that is offset by the potential to benefit from a quick directional move.
Trade Evaluation: On the expiration date of the June (Monthly) 80 call, the trade will be at break-even or better if PG is above $77.50, and will show a profit of at least 40% if PG is above $79. If PG is at $80 or higher, the trade will have a profit of about 60%.
Comment: At the June expiration date with the stock at $80, the July (monthly)75 call by itself would show a profit of only 46%.
Trade Continuation: If PG has not reached $80 when the June expiration date arrives, the June (monthly) 80 call will expire worthless and the July (monthly) 75 call will have a reduced cost basis of $3.25. This option can then be held for unlimited future gains.
Since PG has weekly options, there is an opportunity to continue this trade on a week-by-week basis as you wait for the PG stock price to move up. The premium received from the sale of a weekly call can help offset the time decay in the long option until PG makes its move.
Trade Continuation with weekly options: If PG is below $80 at the June (monthly) expiration date, the June weekly 80 call might be sold for $.25. This will reduce the cost basis of the July (monthly) 75 call to $3.00 while still allowing for plenty of upside potential for a profit.
Management of the Diagonal Spread: The key to the diagonal spread is keeping track of the deltas of the two options. When the trade is initially established, the short option will be out of the money and have a delta of lower magnitude than the long option. If the underlying stock moves quickly and extensively in the desired direction, it is possible for the delta of the short option to outpace that of the long option and even lead to a losing trade. This is the same problem seen in a horizontal spread. When setting up the trade, it is wise to consult a risk graph to determine the most extreme move of the underlying stock that will still yield a worthwhile profit in the diagonal spread. It may be necessary to move the strike price of the short option further out-of-the-money in order to guard against a losing trade when the underlying stock moves farther than anticipated.
What stocks are most suitable for diagonal spreads? Stocks that offer numerous strike prices are best. This permits flexibility in selecting an option to short that will yield a reasonable premium while still allowing for ample price movement. Also, as mentioned above, stocks that have weekly options provide additional flexibility to adjust the trade regularly in response to price movement.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.