A diagonal options spread involves selling options contracts with near-term expiration dates, and then buying the same number of contracts with later expiration dates at a different strike price. The contracts for both legs -- sold and bought -- will be the same type -- puts or calls. The initial goal of the spread is to earn the premium from the sold options. The purchased options with the later expiration date provide protection against an unexpected stock price move and future profit potential. You may want to close a diagonal spread early if the near month options go into-the-money, and you want to avoid the potential of an early assignment on the sold options.
Enter a buy-to-close order for the near expiration options you previously sold. The contracts will show as short holdings on your brokerage positions screen. Enter a buy order to close the short holdings position. It is important for margin requirement reasons to always close the short side of an options spread trade first.Step 2
Evaluate the profit potential of the remaining leg of the spread -- the long options position with the extended expiration date. The remaining options will profit if the underlying stock moves in the correct direction -- up for calls, down for puts -- to be in-the-money by the expiration date. Once the front leg of a diagonal has been closed, the remaining leg is a low-risk long call or put position.Step 3
Enter a sell to close order for the remaining options from the initial diagonal spread trade. Selling the contracts brings money into your brokerage account, based on the current option prices. This step can be completed at any time up to the expiration date of the options.
- Options as a Strategic Investment, Lawrence G McMillan, 3rd edition, Chap. 14
- Options Playbook: What is Early Exercise and Assignment
- A diagonal spread is a combination of a vertical spread and a calendar spread. Understand how these two easier-to-understand spreads function before trading diagonal spreads.
- If you made a profit from buying back the near expiration short options, you can sell more options with the expiration date of the long options leg, setting up a vertical bull or bear spread.
- Your brokerage account online system might offer the ability to close complicated option trades with a single order. If you have that capability, it can quickly exit your account from a diagonal spread trade that is not working as planned.
- Trading diagonal options spread strategies requires an in-depth understanding of how options work and the potential outcomes as the underlying security moves up or down in value. The strategy poses relatively low loss potential, but must be properly managed to generate the desired profits.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.