Diagonal Spread

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21 Aug, 2024

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The diagonal spread is a popular options trading strategy that involves the simultaneous purchase and sale of options of the same type but with different strike prices and expiration dates. This spread aims to benefit from the advantages of both vertical and calendar spreads.

The strategy offers traders greater flexibility compared to other options strategies, allowing them to take multiple positions and potentially purchase options at a lower cost. However, it is important to note that, like all options trading strategies, the diagonal spread carries associated risks, such as losing money if the underlying security does not perform as expected. Additionally, traders may incur higher fees than other strategies, as they effectively buy and sell two options contracts.

What Is A Diagonal Spread?

The diagonal spread strategy in options trading involves buying and selling options of the same type but at different strike prices and expiration dates.
This spread strategy's main goal is to utilize the advantages of both the vertical and calendar spread techniques while trading options.
It is different from the calendar and vertical spread. In the calendar spread, only the expiration dates are different, and in the vertical spread, strike prices are different.
The types of diagonal spreads include diagonal call and put spreads.

Diagonal Spread Strategy Explained

A diagonal spread is a type of options spread that combines aspects of both horizontal spreads and vertical spreads. By using options with different strike prices and expiration dates, the strategy can help lower costs compared to other spread strategies. Furthermore, traders can use call or put options and take either long or short positions when implementing it.

The main advantage of it is that they allow traders to manage risk by taking multiple positions at different strikes and expiration dates. However, it is important to consider market volatility and timing when entering and exiting the spread, as it can also result in higher commission fees. Therefore, investing a smaller amount when entering a diagonal spread is also recommended to manage risk.

Diagonal spreads can be used by various traders, including options traders, hedgers, and speculative traders. Options traders use it to take advantage of time decay and volatility in the market. Hedgers can use it to reduce risk by taking multiple positions at different strikes and expiration dates. Finally, speculative traders may use it to profit from market movements, but it requires a good understanding of market conditions, volatility, and timing. In general, diagonal spreads can be used by traders with a moderate to high level of experience and risk tolerance.

Adjustment

The traders have to make certain adjustments while trading an options contract. A diagonal call spread is a popular options trading strategy. It involves buying a call option at a specific strike price and expiration date and selling another with a different strike price and expiration. The spread can be adjusted during the trade; for example, the short-call option can be bought and sold at a lower strike price closer to the stock price if the underlying stock price drops sharply before the first expiration.

Selling a put option with one strike price and one expiration and purchasing a second put option with a different strike price and expiration indicates the put diagonal spread strategy. During the deal, spreads can be changed to increase credit. For example, the short put option may be bought and sold at a higher strike price nearer the stock price if the underlying stock price rises sharply before the first expiration.

Example

A simple example is buying the $10 option with an expiration date of 10 June 2023 and selling the $15 option with an expiration date of 10 January 2023. In this case, the trader bought an option with a longer expiration date and a lower strike price and sold the option simultaneously with a near-expiration date and a higher strike price.

Graph

Let us look at the graph for a better understanding:

The two strike prices are S-1 and S-2.

S-1: Strike for short option

S-2: Strike for the long option

Diagonal Spread vs Calendar Spread vs Vertical Spread

Although diagonal, calendar and vertical spreads are options spread, there is are differences between them. While the vertical spread allows traders to trade at different strike prices, the calendar spread focuses on having different delivery dates, and the former also performs differently. It is a mixture of the calendar and vertical spreads where they can buy and sell simultaneously at different strike prices and expiry dates. However, they all aim to hedge and adjust this strategy's risks.

Basis	Diagonal Spread	Calendar Spread	Vertical Spread
Meaning	It is a combination of both vertical and calendar spreads.	Obtaining a long and short position simultaneously on the same underlying asset but with different delivery dates.	Simultaneous buying and selling options of the same underlying asset but with different strike prices.
Purpose	To reduce the time effect and make a profit.	To hedge and reduce the risks	To reduce the premium amount payable.
Types	Call and put types.	Call and put types.	Call and put types.
Also known as	Diagonal call spread or diagonal put spread.	Horizontal spread or a time spread.	The price spread or a money spread.

Frequently Asked Questions (FAQs)

Are diagonal spreads profitable?

A diagonal spread trade may be successful if the spread goes into the "in the money" phase or increases in value before the long option expires. The asset in the transaction that the trader desire to increase in value is the long option, while the short option lowers the long option's cost basis.

What is a double diagonal spread?

It is a multi-leg options trading strategy that simultaneously buys and sells both call options and put options with different strike prices and expiration dates. This strategy aims to benefit from the bullish and bearish market move and generate a profit through the time decay of options and changes in the underlying stock price.

Is the diagonal spread strategy risky?

Trading multiple options with varying strike prices and expiration dates is part of the diagonal spread strategy. However, using it appropriately reduces its risk. In essence, the trader should have substantial technical expertise and practice.