Ken Trester

Profits on the Diagonal

by Ken Trester   08/19/08

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.