An option gives you the right, but not the obligation, to buy or sell the underlying stock at a set price, called the strike price, for a specified period of time which ends at the expiration date. A diagonal spread is a sophisticated option strategy that involves buying and selling the same kind of option in the same security, but with different expiration dates and different strike prices. When you close a diagonal spread, it is important to enter your transactions in the proper order.
Enter a buy-to-close order for the same security, strike price and expiration date of your short position. Your short position is the option that you sold. For example, if you sold an option on XYZ stock with an expiration in December and a strike price of $35, you would close your short position by purchasing an XYZ $35 option with a December expiration.
Evaluate your current long position and consider how the market is performing. Your long position is the option that you purchased. In a diagonal spread, your long position must always have a longer expiration date than your short position. Once you've closed your short position, you still own your long option. If the stock price appears like it will remain static, you might consider selling another option against your current long position to create another diagonal spread. This will generate additional income. If it appears the stock price is moving in the direction of your long position, you might consider holding your long option to take advantage of its increased value. The the stock price is moving away from your long position, you might want to sell your long option to prevent additional price erosion.
Close your long position by entering a sell-to-close order for the same security at the same strike price and expiration date. Make sure your short position is already closed before you enter the order. Just because you entered an order to close your short position, doesn't mean it has executed. If you close your long position before your short position is closed, you risk factor increases exponentially.
- Always close your short position before closing you long position. If you close your long position before you close your short position, your risk increases significantly, because your short option position is naked, which means you don't own the underlying stock. If the option is exercised against you, you'll have to buy the stock in the open market in order to deliver it. Your risk, at least in theory, is unlimited.
- Trading diagonal spreads is a conservative investment strategy when employed correctly, but it is a sophisticated technique and is not appropriate for all investors. You can lose money by trading diagonal option spreads.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.