CHAPTER 7

Double Diagonal Spreads

The vertical spread was formed by buying and selling the options in the same expiration month. We can diagonalize that spread by buying and selling the two options in different months and at different strike prices. Similar to a double calendar spread, we may establish two diagonal spreads, one positioned above the current index or stock price, and one positioned below the current index or stock price. This is the double diagonal spread, a delta-neutral option trading strategy.

DIAGONAL SPREADS

All of the vertical spreads we studied earlier can be diagonalized, but, in practice, it is most common to diagonalize the bull call spread. In August 2009, IBM was trading at $120. Let’s assume I had a long-term bullish outlook for IBM, so I bought the January 2010 $110 call for $13.75 and sold the September $120 call for $3.05, for a net investment of $10.70. I have effectively bought a call spread on IBM, stretched out over time. I would manage this trade by tracking the cost basis of the long call. The cost basis starts out at $10.70. As we approach September expiration, IBM is trading at $122, so we buy back the Sept call for $2.20 and sell the Oct $120 call for $4.60 for a net credit of $2.40. Now my cost basis in the Jan 2010 call is $8.30.

As we approach October expiration, IBM has traded up to $128 and the earnings announcement is imminent. We now have a choice. If I am bullish on IBM, I could buy back the Oct $120 call for $8.65 and sell the Nov ...

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