Diagonal Spreads Explained

A Diagonal spread is an excellent choice when you have a strong directional bias and have identified a strong resistance/support level. It is also an excellent strategy for creating monthly dividend-like income. This strategy is very similar but much better than a covered call. So, if you like covered calls, you should try this instead.

Basic transaction:
If you are bullish on the stock.
Buy lower strike In the money (ITM) call with long expiration
Sell higher strike out of money (OTM) call with short expiration
This trade is shown below in the risk profile graph.

OR
If you are bearish on the stock.
Buy higher strike ITM put with long expiration
Sell lower strke OTM put with long expiration
The risk profile will the similar but opposite to the risk profile below.

Risk Profile:

Dec Call costs 2.9/contract
Oct Call costs .3/contract

Strategy:
You bias on a call diagonal is bullish and a put diagonal is bearish. The basic reasoning for trading a diagonal is that it reduces your cash outlay, thus increasing your ROI. Also, you can use a diagonal campaign to give yourself dividends on a month-to-month basis. Finally, Diagonals reduce your risk in case your hypothesis is wrong. All these are explained below in more detail.

But first, I will illustrate what would happen if you simply bought a call contract. If you bought a Dec call contract for strike 41, your cash outlay would be $2.9/contract. If in case the stock goes south of 41, your max loss is thus $2.9. Your max profit is infinite if the QQQQ's rise forever. Your infinite profit scenario is highly unlikely. What is more likely is that you will identify some resistance/target level that you expect the QQQQ to reach. Let's say this target is $44. At $44, your profit is .92/contract. That is a ROI of 31% when the stock moved a mere 4%. That is a pretty sweet deal. But, with a diagonal, you can do better.

Increasing ROI:
Again, assuming the Dec call costs 2.9/contract, let us also assume that the Oct call strike 44 costs .30/contract (these are actual prices I got while making this post). So you buy the Dec contract and sell the Oct contract, reducing your cash outlay by 10% right away. Thus, any profit you make will have a higher ROI. Additionally, for any stock price below the short short contract, you will have a higher profit than simply with a long call.

For instance, let us say that the stock moved up to $44. Your profit is 1.07/contract, increasing your ROI to 41%.

Dividend Play:
Assume you carried out the trade explained above and by Oct expiry the stock is between $41 and $44 and your bullish outlook still holds. Well, you can go ahead and sell Nov contracts (strike will depend on your outlook for the QQQQs at that point) and rake in another 10% or so. If you had bought Feb contracts instead of Dec, you could do this every month and make around 40% just from selling the OTM contracts.

Reducing Risk:
Going back to the original Oct/Dec diagonal, because your initial cash outlay is lower, in case the QQQQ's fall dramatically, your max loss is much lower compared to if you had simply bought a long contract. This is best illustrated by the fact that the QQQQ's have to hit $31 to achieve a max loss scenario of $2.6/contract for the diagonal trade. On the other hand, anything below $41 gets you max loss of 2.9/contract for the long call. Thus, not only is your max loss lower but also harder to get to.
Of course, you would sell this position off before reaching max loss, but the above point holds true for all QQQQ's prices.

The one drawback of the diagonal spread is that if the stock moves above $44, your profit is capped and in fact you start losing some money after $44. For example, if the stock moves to $54, you will make only $.42/contract. If the strikes for the trade are close enough (for example 41-42 strike diagonal), you could even loose money as the stock keeps going higher. So be mindful of this when trading diagonals.