When doing option trading, there are so many possibilities and combinations of options that we could buy and sell. A lot of these trades have some pretty exotic names. With a diagonal spread, we are buying and selling calls at the same time or buying and selling puts at the same time. The strike prices are different and the expirations are different.
I am not going to use any examples that would require approval of level 5 which would be uncovered calls. This is not something that most brokers allow because there is unlimited risk. With this in mind, we need to remember that the option that we sell is going to be a shorter time frame than the option we buy.
The reason for doing this trade is to offset the cost of the option we are buying. We are also looking to take advantage of time decay in the shorter option. Ideally, we are looking for the short option to expire worthless but close to being in the money.
In this trade, if the short option is going to be in the money at expiration, we need to buy back the option. We do not want to have to exercise our long option which will still have time value in it. We can buy back the short option and hold on to the long option or we could close out of the trade entirely by also selling our long option at the time we buy back the short option.
Depending on how much time we have on the long option, we could continually sell shorter time frames and let them expire and then short again for a later time frame. The key is to always be aware of what the short option is doing. If it is going to be in the money at expiration, we are looking to buy back that position.
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