Profits on the Diagonal

If you’re like most investors, you have pretty strong opinions about which way a stock will move, but you may not be sure of the timing — that is, exactly when that expected move is actually going to happen.

The best way to capitalize on your directional convictions, while allowing some extra time for your speculation to pan out, is through establishing a diagonal options spread.

In general, a spread position comprises trading two or more options on the same underlying stock. With a diagonal spread, both options are the same type (either two calls or two puts) but each has a different expiration date and strike price.

“Diagonal” refers to a trade having a difference in both strike price and time horizon, as opposed to a horizontal trade (whose options share a strike price) and vertical trades (whose options share an expiration date).

LEARN A NEW ANGLE ON MAKING OPTIONS PROFITS

The benefit of a diagonal spread is that it allows you to trade one leg of the spread with extra time associated to it.

For example, let’s say that you believe oil refiners are going to hit a slump after the summer driving season ends, but you’re not sure whether the hit will come in September or October.

You choose to use what’s called a bull-put diagonal spread on Chevron (CVX) options to capitalize on your belief that the stock will falter but without having to put all your money on one particular options expiration date. In a diagonal spread, you will write (or, sell to open) an option at a particular strike price in one month and buy (or, buy to open) a lower strike price in a different month.

Here’s an example using Chevron while it is trading at $85 per share:

You would sell the Chevron September 85 Puts for $2.30 (for a credit of $230 per contract).

In a simultaneous transaction, you would also buy the Chevron October 80 Puts for $1.50 (for a debit of $150 per contract for this leg of the trade).

In total, then, your put spread would give you a net credit of 80 cents per share, or $80 per contract.

If Chevron closes above $85 on expiration Friday in September, then your Chevron September 85 Puts will expire worthless, leaving you with a net profit of 80 cents per share, which you collected when you initiated the trade.

Now, at this point, you would still own the Chevron October 80 Puts, which you can sell to capture any remaining time value, which increases your net profit.

However, if Chevron does not close above $85 per share at September options expiration, you can buy back (or, buy to close) your Chevron September 85 Puts to unwind the short position, and then sell (that is, sell to close) the Chevron October 80 Puts for additional premium.

Should Chevron drastically change direction at any point and start dropping, you are covered with your October 80 Puts because this is a long position. You can buy back to close your September 85 Puts and keep the October 80 Puts open and watch the value increase as the underlying Chevron stock slides.

BUYING — AND KEEPING — TIME ON YOUR SIDE

Conversely, if there’s a stock you feel will climb in the short term, but you’re not certain of the timing, you can also execute a diagonal call option spread. This is ideal for producing income for your portfolio because the spread profits from time premium decay while requiring less capital than buying a single call option outright.

The strategy for a diagonal call spread is simple: You buy a call option that is deep in-the-money — that is, its strike price is lower than the market value of the shares — and at least five months away from its options expiration. At the same time, you sell a call option with a higher strike price — ideally one that’s out-of-the-money, which means the strike is above the market value of the shares — that expires within the next 45 days.

Let’s do one more example. Suppose you expect the retail sector to have a stellar holiday season, and Kohl’s (KSS) is one of your favorites. With Kohl’s trading in the $50 area, you might buy the Kohl’s October 50 Calls for $5. Then you sell the Kohl’s January 60 Calls against them for $2.50.

As in the Chevron example, you’re collecting premium to offset the purchase of an option to hold long. In the previous example, you collected more on the short leg of the trade than you spent on the long one. And in the Kohl’s example, the short option enabled you to spend less to enter the trade than you would have to buy the Kohl’s October 50 Calls.

If Kohl’s trades higher, it will cause the lower-strike-price option that you own (the October 50 Calls) to increase in value. If the stock stays below the higher strike price (the January 60 Calls), you simply reap the income from the sold position. Then if the short option expires worthless — and you keep your premium — you can sell another higher-strike-price option against the in-the-money call with the later expiration date that you still hold.

This position isn’t without risk, because if the stock takes a wrong turn and declines, your long in-the-money calls may move out-of-the-money and you run the risk of being assigned those calls at the $60 strike. (This means that someone who established a long position in your short October calls could force you to buy stock at the exercise price). There is a risk that, no matter whether a short option position is in-the-money or out-of-the-money, the option-holder has the right to assign the option-seller to honor the obligation that shorting an option entails.

If you would happen to be assigned, you could buy stock at the $50 strike of your long call to cover the obligation of the short $60 call. So, it may be a wise choice to keep the spread value as low as possible because you’ve got time on your side to tailor your position accordingly!

While it’s true that the fastest way from point A to point B is a straight line, a diagonal spread can be a relatively steady way to profits!

If you enjoyed this article, check out Ken Trester’s “Selling Options Can Generate Instant Profits” and “Short-Term Gains Using Long-Term Options.”