Ken Trester

Profits on the Diagonal

by Ken Trester   08/19/08

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.