What is a diagonal option trade?
A diagonal is when you purchase calls or puts with different strike prices and expiring at different times.
Examples:
- Purchase a $75.00 call expiring in 6 weeks and sell a $70.00 call expiring in 2 weeks.
- Purchase a $40.00 put expiring in 2 months and sell a $45.00 put expiring in one week.
- Purchase a $100 call expiring in 6 months and sell a $150.00 call expiring in one week.
I could continue with examples but I think you get the picture. The strikes are different and the expiration’s are different.
I use diagonals a couple of different ways in my trading.
- As a type of covered call trade substituting a long term option for the purchase of the stock.
- As a time decay type of trade.
- Hedges
As a covered call type of trade I would substitute a long term option expiring in the distant future for the stock itself. I like to try and find an option expiring at least 3 months away with a delta of over 90 and as close to 100 as I can get. The reason I like the high delta is so the long option will move in similar manner as the stock. The higher the delta the close the option price changes to the stock price.
There are some exceptions to my delta rule especially with really high priced stocks, but if you are confident the stock price is moving up or range bound you need to get as high of delta as possible on your long option. Otherwise, you are paying for time as well as intrinsic value of the option. You want to pay as little for the time value as possible.
The other way I use diagonals as part of time decay strategy. This is similar to other time decay strategies in that you want to sell more time decay value that you are purchasing.
As an example if you are selling an option that expires in 7 days and is trading at $.60 of time value then the amount of time decay on this option per day is $.08/day ($.60/7). If you are purchasing an option that expires in 28 days and is trading $1.20 then the amount of time decay on this option is $.04/day ($1.20/28). Based on these numbers you are selling $.08/day and buy $.04/day. When trading a time decay strategy this is what you are looking for.
I will be posting examples of different types of trades on the site that you can use as examples of different types of diagonal trades.
