Short-term Stability, Long-term Bullish Outlook: How to Use the Diagonal Bull Spread Strategy

When investors believe a stock's price will remain neutral or bearish in the short term but bullish in the long term, the diagonal bull spread strategy can be an effective choice. Compared to a traditional bull call spread, a diagonal bull spread can better reduce upfront costs when the stock price is stable or declining in the short term. In some cases, it may even allow investors to effectively obtain a call option "for free."

What is a Diagonal Spread?

A diagonal spread is an options strategy that uses options with different strike prices and expiration dates. Typically, the long leg (buy) of the spread has a longer time to expiration than the short leg (sell). Diagonal spreads include both diagonal bull spreads and diagonal bear spreads. Today, we'll focus on the diagonal bull spread.

Understanding the Diagonal Bull Spread

The bull call spread strategy involves buying a call option with a lower strike price while selling a call option with a higher strike price, both expiring on the same date. This strategy reduces the net cost compared to simply purchasing a call option, as the premium from selling the higher strike call offsets part of the cost. The overall break-even point is lowered, increasing the likelihood of profitability. Essentially, it's a cost-efficient way to buy a call option.

The diagonal bull spread builds upon the bull call spread by introducing options with different expiration dates. Investors buy one long-term call option with a lower strike price and sell one short-term call option with a higher strike price, maintaining equal quantities for both legs.

Advantages of the Diagonal Bull Spread

This strategy can often improve upon a traditional bull call spread. If the stock price remains stable or declines slightly before the short-term call option expires, the diagonal spread becomes advantageous. Once the short-term call option expires, investors can initiate a new spread, effectively transforming the position into a regular bull call spread.

Practical Example

On December 7th, Tesla's stock price was $334. An investor expecting Tesla's stock price to remain relatively stable or decline slightly in the short term, but to rise in the long term, could consider using a diagonal bull spread.

Here’s the setup:

• Sell a call option expiring on December 20, 2024, with a strike price of $400 (receiving a premium of $220).

• Buy a call option expiring on December 20, 2024, with a strike price of $335 (paying a premium of $1,589).
  The total cost of this trade is $1,369.

Potential Outcomes

1. Best Case Scenario:
   By expiration, Tesla’s stock price remains below $400 but significantly above $335. The investor collects the full $220 premium from the short-term call and also profits from the long-term call option, effectively reducing the cost of their bullish position.

2. Worst Case Scenario:
   If Tesla’s stock price falls sharply below $335, the investor faces a maximum loss of $1,369, the total amount invested.

Conclusion

Diagonal spreads, including the diagonal bull spread, are versatile strategies. In certain situations, they allow investors to significantly lower the cost of purchasing a call option or, in some cases, obtain a call option at no net cost. This approach is not limited to bullish scenarios and can be adapted for other types of spreads.