Example Trade #1: In early April, XYZ is trading at $150 after a modest pullback. You feel that XYZ will likely be moving up sometime during the next six weeks.
Trade #1: Buy 1 May (monthly) 150 call for $2.45 and sell 1 Apr (monthly) 153 call for $.30. Net cost is $2.15.
Comment: Note that the premium received from the sale of Apr 153 call has reduced the cost basis by about 12%, which is significantly less than what would be expected in a vertical or horizontal spread. The diagonal spread is typically more expensive than a vertical or horizontal spread, but that is offset by the potential to benefit from a quick directional move.
Trade #1 Evaluation: On the expiration date of the Apr 153 call, the trade will be at break-even or better if XYZ is above 150.60, and will show a profit of at least 45% if XYZ is above $152.50.
Trade #1 Continuation: If XYZ has not made the expected move when the Apr 153 call expires worthless, the May 150 call will have a reduced cost basis of $2.15. This option can then be held for unlimited future gains.
If XYZ has weekly options, there is an opportunity to continue Trade #1 on a week-by-week basis as you wait for the stock price to move up. The premium received from the sale of a weekly call can help offset the time decay in the long option until XYZ makes its move.
Trade #1 Continuation with weekly options: If XYZ has not made the expected move when the Apr 153 call expires worthless, the May 150 call will have a reduced cost basis of $2.15. If XYZ is still around $150, the Apr weekly 152 call might be sold for $.25. This will reduce the cost basis of the May 150 call to $1.90 while still allowing for plenty of upside potential for a profit.
Note that in this continuation with selling a weekly option, the short strike was dropped from 153 down to 152 in order to capture more premium from the short call. This would be done only if it was felt that the anticipated upward move in XYZ might be delayed beyond the expiration date of the weekly option.
Management of the Diagonal Spread: The key to the diagonal spread is keeping track of the deltas of the two options. When the trade is initially established, the short option will be out of the money and have a delta of lower magnitude than the long option. If the underlying stock moves quickly and extensively in the desired direction, it is possible for the delta of the short option to outpace that of the long option and even lead to a losing trade. This is the same problem seen in a horizontal spread. When setting up the trade, it is wise to consult a risk graph to determine the most extreme move of the underlying stock that will still yield a worthwhile profit in the diagonal spread. It may be necessary to move the strike price of the short option further out-of-the-money in order to guard against a losing trade when the underlying stock moves farther than anticipated.
What stocks are most suitable for diagonal spreads? Stocks that offer numerous strike prices are best. This permits flexibility in selecting an option to short that will yield a reasonable premium while still allowing for ample price movement. Also, as mentioned above, stocks that have weekly options provide additional flexibility to adjust the trade regularly in response to price movement.