Trading Diagonal Spreads (Part Two)

01/20/2010 12:01 am EST


John Jagerson

Co-Founder and Contributor,

John Jagerson of Learning Markets shows the steps for entering a diagonal spread trade.

In the second article of this series on selling covered calls against LEAPS, or diagonal spreads, I will begin walking through the entry process with a case study. The numbers and real-life scenario should help you understand how these trades work and why they are attractive, but if you really want to remember the information, you should paper trade it a few times yourself. Going through the process by hand will help you remember the process.

In the case study, I will use an index option with European-style expiration. This solves the problem of early exercise that I mentioned in the first part of this series.

Because European-style options can only be exercised at expiration and not before, the index option I will use is the mini SPX index option (XPS). The XPS, or mini version of the SPX, is good for smaller traders as the options are only one-tenth the price of the normal SPX options.

You can find more information about trading short options and covered calls below.

Step 1: Buy the Long-Term Option

First, we need to buy the long-term option at least a year out before expiration. In the case study, this means buying the December 2009 calls.

The long-term options purchased can be very far in the money if you wish, but I typically suggest buying one strike price in the money. Assuming a current XPS price of $93, that means I would buy the $90 strike price calls for $1,615 per contract.

Step 2: Selling the Short-Term Option

In my experience, buying a far-in-the-money long-term call does not materially impact returns compared to a call that is very near to the at-the-money strike price.

What is important, however, is that in the next step, you sell a short-term call with a strike price above or further out of the money than the call you bought. In this case, that means I would sell the December 2008 95 strike price calls for $535 per contract. The rate of return just based on those prices is more than 30%. Of course, risk and time value will eat away at that best-case scenario.

At this point, the trade looks very similar to a covered call. The long-term option takes the place of the long stock and protects against the unlimited losses that may occur with a short option alone. In the next section of this series, I will cover what happens if you are "called out" of a trade like this at expiration.

By John Jagerson at

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