Trading Diagonal Spreads (Part One)

01/19/2010 12:01 am EST

Focus: OPTIONS

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

Diagonal spreads can be a great way to increase profits on a strategy you are probably already familiar with.

Covered calls are a great strategy for reducing account volatility and earning income on your long stock positions. We have also talked about using LEAPS options as a way to "lease" stocks for less money than it costs to acquire the stock outright.

Is there a way to combine the benefits of these two investing strategies to get the best of both worlds? Yes, there is, by selling covered calls against a long LEAPS option position, also known as diagonal spreads.

This series of articles discusses the covered calls on LEAPS, AKA diagonal spreads, strategy. If you have a basic background understanding of covered calls and LEAPS, this should be something you will be interested in. If you need a refresher on these subjects, please check out the links below.

In part one, we will start the discussion about covered calls on LEAPS by looking at the risk profile of that trade compared to its potential benefits. A covered call on LEAPS has distinct advantages, but understanding the risks is important as well.

Here are a few of the key concepts to keep in mind when trading a covered call on a LEAPS option:

Risks

1. You are short a call without an underlying stock position. This means that if you are "called out," you could find yourself short the stock.
2. A LEAPS option has time value that is melting each day as you near expiration.
3. Option trades are often at a higher commission rate and this will increase your trading costs.

The benefits of trading a covered call on a LEAPS option are also very significant. I have outlined a few of those in the list below:

Benefits

1. The LEAPS contract is cheaper than the underlying stock, and this increases your leverage and potential profits.
2. Because the LEAPS contract is cheaper, you have less risk in absolute dollar terms than holding the underlying stock.
3. This is a strategy that can be used with index options as well as stocks and ETFs.
4. Using it on index options with European-style expiration eliminates the slight possibility of early exercise.

Balance the risks and benefits to decide whether this strategy works for you and to help you decide the best way to implement it within your portfolio. As we release this series of articles, I will use a case study to illustrate the concepts.

Repeat the steps in the case study on an option of your choice in a paper trade. Repeating the method yourself will help you understand the strategy and remember how it works.

By John Jagerson of LearningMarkets.com

Learning Markets offers daily articles, videos, and investing guides—for free—about everything from investing in stocks and options to trading currencies in the forex market and more. Visit LearningMarkets.com to learn more about investing and to interact with other investors just like you.

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