Trading Diagonal Spreads (Part Three)

01/21/2010 12:01 am EST

Focus: OPTIONS

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

Diagonal spreads can lead to interesting problems at expiration if the short call is in the money. There are three concepts you should be aware of when dealing with an in-the-money short call, and this article will discuss these concepts and their different effects. Keep in mind that like a true covered call, if the short option expires out of the money, there are no additional actions needed and you will get to keep the entire premium.

American-Style Stock Option: Most options on stocks and ETFs are American-style expiration, which means that if your short call is in the money, it can be exercised at any time. Although early exercise is rare, it does happen.

If the option is in the money at expiration, it will most likely be exercised. Because you don't actually own the stock when you are exercised, your broker will probably short the stock in your account. If you are not prepared for this, you should avoid selling, or writing, American-style options.

European-Style Index Option: In this series, we used a European-style index option on the XPS. This style of execution means that you cannot be exercised early.

If the option is in the money, you may need to take some action by expiration, but you don't need to take action before that time. If you do not want to be exercised at expiration, you will need to buy the option back at its current market price before expiration.

Cash Settlement: Most European-style index options like the SPX or XSP are cash settled. That means that if at expiration, the option has a value of $100, you will have $100 withdrawn from your account to pay for the "exercise." If you had been long that option when it expired, you would have had the $100 deposited in your account.

These options are cash settled because there is no underlying stock. They represent an index rather than a real stock, and therefore, you don't have a potential short stock position like you might with an American-style option.

In the next section, we will talk about what happens if the market declines. This is good for the short call position because it is more likely to expire out of the money, and you then get to keep the entire premium. However, there will be losses on the long-term call. We will cover when you should consider exiting the entire position and re-enter after a larger drop in the underlying stock or index.

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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