A diagonal spread is a 2-legged option strategy where you buy a call (or put) with a distant expiration, and sell a call (or put) with a different strike price and a closer expiration date.
One of the more common forms of diagonal spreads is a diagonal call spread using an in-the-money Long Term Equity AnticiPation Securities® (LEAPS®) call option as the long leg, and selling an out-of-the money call with a much closer expiration date.
Because the time value erodes faster on the near-term option than on the LEAPS option, many traders use this strategy as a way to generate short-term income which helps to reduce the overall cost of the long leg.
This strategy is sometimes called a synthetic buy/write, because the long-term option is being used as a substitute for a long equity position, but there are some important differences, primarily:
- This strategy is actually a spread, not a covered call (buy/write).
- The long option represents “potential” ownership in the stock, not “actual” ownership.
- There is an additional cost to establish stock ownership when/if exercised.
- Option owners are not entitled to dividends (if any) and have no voting rights.
What are LEAPS?
LEAPS (an acronym for long term equity anticipation securities) are options that expire much later than traditional options. Traditional options usually expire in nine months or less. LEAPS, on the other hand, can expire up to about three years in the future. While over 3,500 stocks trade options, only about 2,500 trade LEAPS. However, a lot of the largest and most actively traded stocks, ETFs and Indexes have LEAPS.
A long LEAPS option is not a perfect substitute for a long stock position. Since the long leg of a LEAPS diagonal spread is a call option with many months until expiration, you have the right (but not the obligation) to exercise the call at any time (up until expiration) to acquire the underlying stock at the strike price. The LEAPS option can also be sold rather than exercised. By contrast, the owner of a long equity position in a traditional buy/write options strategy would already own the underlying stock.
Additionally, since you have sold a shorter-term call option, you have also taken on an obligation to sell stock at the strike price to the long call holder (if you are assigned) at any time up until expiration of the short call. If the short call expires in-the-money or you are assigned early, you would need to acquire the stock in the market to cover the assignment. That acquisition can be done by exercising the long LEAPS call option or by buying the stock in the market. In most cases, exercising may not make sense since the time value will be lost, thus the sale proceeds of the long LEAPS call would be greater. By contrast, the owner of a long equity position in a traditional buy/write strategy would already own the underlying stock.
How do I set up a diagonal spread?
When you select your in-the-money LEAPS call option, you have to decide how far in-the-money you are willing to go. Deeper in-the-money options will cost more but they will also behave a lot more like the underlying stock; thus more closely approximating the buy/write strategy. All options have delta, which estimates how much the option price changes relative to the underlying stock's price change. A slightly in-the-money call option with a delta around .60 will cost less than a deeper in-the-money option with a delta around .80, but (initially) it will only change in price theoretically about $0.60 for every $1.00 change in the price of the stock. A call option with a .80 delta should (initially) change in price about $0.80 for every $1.00 change in the price of the stock.
Delta can also be viewed as a real-time estimate of the probability of a particular option expiring in-the-money. So if you purchase a long LEAPS option with a delta around .80, at that moment, the estimated probability of that option expiring worthless is only about 20%. This is not to say that you will earn a profit, only that there is about an 80% probability that your option will have at least some value at expiration.
Let's look at an example.
Buy/write versus diagonal spread example
Assume it’s July 2020 and XYZ is currently trading at a price of 78.72. In the case of a traditional buy/write, you might buy 1000 shares of XYZ @ $78.72, and sell 10 XYZ 08/21/2020 80 calls @ 2.25. The total cost of this buy/write is $76,470 ($76.47 x 1000 shares).
While your total risk (maximum loss) is limited to 76.47 points (2.25 – 78.72) or $76,470, XYZ would have to drop all the way to zero to incur the maximum loss. Here are the outcomes at a few sample prices that might occur at the expiration date of the short call options.
Source: Schwab Center for Financial Research.
As you can see in the table above with the buy/write:
- The initial cash outlay is $76,470
- At prices above the short strike price, it is possible to earn a profit margin of 4.6%
- If the underlying stock declines modestly, a small profit can be earned
- But when the underlying stock declines more than the credit received from the original option premium, losses will be incurred
As an alternative, you could decide to buy 10 XYZ 01/21/2022 50 calls @ 31.50 (yellow circle below), and sell 10 XYZ 08/21/2020 80 calls @ 2.25. The total cost of this spread is $29,250 ($29.25 x 10 spreads).
While both strategies provide 2.25 points of immediate downside protection, the LEAPS spread initially costs less than half of the cost of the buy/write. The reason of course, is because the 50 calls do not represent actual ownership in XYZ, they only represent potential ownership. And if those calls are exercised to realize that potential, you would have to spend an additional $50,000 to acquire the stock.
Theoretical tool in StreetSmart Edge
Source: StreetSmart Edge.
Using the Theoretical tool (blue circle above) within the options chain in StreetSmart Edge®, you can estimate how much your options will change in value relative to XYZ.
Because the long LEAPS calls you purchased (which expire in 18 months) are deep in-the-money, they have an initial delta of approximately 0.81 and will initially decline in value by approximately $0.81 if the stock immediately declines $1.00. However, delta is a continuously calculated value and it typically decreases as the price of the underlying stock decreases. After another $1.00 decline in the price of XYZ, the delta goes down and the LEAPS will likely only lose about $0.78 (red circle). If XYZ dropped about $2.00 immediately (pink circle), your long calls should drop to a midpoint price of about $27.57 (green circle) or about 1.60 points below the current original midpoint price of $29.18.
Keep in mind that the long LEAPS option includes only about 0.46 points of time value (because the option is more than 28 points in-the-money) so if it took XYZ a couple of months to drop 2 points, you would likely end up with just slightly less than two points of downside protection due to a small amount of time value erosion. This happens because long options also decay in value over time. Theta is a measure of this time decay. In this case, the theta (brown circle) indicates that this option will lose about $.005 (half a penny) each day even with no price change in XYZ.
While your total risk (maximum loss) is limited to 29.25 points (2.25 – 31.50) or $29,250, if XYZ drops to 50 or below by January 21, 2022, your long LEAPS will expire worthless and the maximum loss will be incurred. Here are the outcomes at a few sample prices that might occur at the expiration date of the short call options.
Diagonal LEAPS Example
Source: Schwab Center for Financial Research.
As you can see in the table above with the LEAPS diagonal spread:
- The initial cash outlay is $29,250
- At prices above the short strike price, it is possible to earn a profit margin of up to 6.0%
- But when the underlying stock declines, losses may be incurred
- If XYZ drops sharply, both options could expire worthless and losses could be substantial
What are the benefits and risks of a LEAPS diagonal spread strategy?
A LEAPS diagonal spread can be a good illustration of the double-edged sword of leverage, so I'd like to conclude with some final cautionary points regarding this strategy.
- The initial cost of the LEAPS diagonal spread is substantially lower than the buy/write.
- While the upside profit potential from a percentage standpoint will be greater with the LEAPS spread, it will be smaller from a dollar standpoint.
- While the downside risk will generally be less with the LEAPS spread, maximum loss will be reached with a much smaller price decline.
- With either strategy, if the underlying stock is below the strike price of the short option and it expires worthless, subsequent short options could be sold for later months, lowering the overall cost basis even further.
- If the short option expires in the money, the remaining value of the long LEAPS call should be more than enough to cover the cost of purchasing XYZ to cover the assignment.
- If the price of the underlying stock drops substantially prior to the expiration date, your LEAPS position will lose value and could become completely worthless.
- With a buy/write, the underlying stock would have to drop to zero to become completely worthless.
- With either strategy, if your short calls go in-the-money, you could be assigned at any time.
- While these strategies do limit risk somewhat, they cannot eliminate it entirely. Losses are limited only by the amount of premium received on the initial sale of the short options.
- Unlike stock owners, owners of long options do not have voting rights and are not entitled to receive dividends (if any).
- LEAPS are options so they eventually expire.
- To utilize the LEAPS strategy, you have to be approved for spread trading (option level 2 at Schwab), and you must have a margin account.
- Buy/writes require only option level 0 at Schwab, and can be done in a cash account.