The Diagonal Spread Strategy

The diagonal spread strategy involves buying an option with a strike price that is far away and selling closer strike prices to generate an income.

For instance say you buy the $90 call 5 months out for $10. You then sell the $95 call 1 month out for $3.

Your Profit

You profit from a trade like this by selling the front month call options on your leap. In the example above you paid $10 to buy the $90 call 5 months out. You made $3 by selling the front month call, so when you start you are negative.

However, say you hold onto it and sell the front month call every month until the option you bought expires. That means you would potentially be profitable after those 5 months. If you make $3 a month then after 5 months your $10 would turn into $15 for example.

Max Loss

If done correctly the most you can possible lose is the price of the call you bought minus the premium you made by selling the front month calls.

You would only receive a loss if

1. The stock goes up fast enough so you will get called out of your front month call. In this case you would have to buy the stock at $90 and sell it at $95, but remember you still paid $10 for the call so this would not be a profit, at least not in the first month.

2. The stock falls sharply making your call worthless. This is the worst case scenario. If you are going to realize your max loss this is how.

Ideally when selling call diagonal spreads you want the stock to be neutral to bullish.

Spreads with Puts

When people think of the diagonal spreads strategy they tend to think bullishly. However you can do the same spread with puts. The only difference is you want to do the spread on neutral to bearish stocks.