Your banner here? Contact us!

Diagonal Spreads in Options Trading

Diagonal Spreads in Options Trading
By Guest Author
September 8, 2023

Options trading has become increasingly popular over the last few decades, allowing traders to speculate on the price of an underlying asset or hedge their positions. One of the more complex options trading strategies is the diagonal spread, which involves the simultaneous purchase and sale of two option contracts with different strike prices and expiration dates. In this article, we will explore what diagonal spreads are, when they may be used, strategies for implementing them, how to set them up, and tips for effectively utilizing them.

What is a Diagonal Spread?

A diagonal spread, also sometimes referred to as a double diagonal spread, is an options strategy constructed using both call and put options. It involves simultaneously buying and selling an option of the same underlying asset, with the sold option having a nearer-term expiration than the bought option.

Specifically, the trader would buy a longer-dated option with one strike price and then sell a shorter-dated option at a different strike price. The bought option serves to establish the position, while the sold option generates income to offset the cost of the trade. The striker prices of the options can both be out-of-the-money, at-the-money, or one in-the-money and one out-of-the-money.

A diagonal spread allows the trader to benefit from continued movement in the underlying asset's price, while also reducing cost through the sold premium. The varying expiration dates and strike prices provide more flexibility to adapt to changing market conditions.

When to Use a Diagonal Spread

There are a few instances when employing a diagonal spread strategy may be advantageous for options traders:

  • When you expect moderate movement in the underlying asset price. The dual option positions allow you to profit from ongoing moves.
  • When implied volatility is high. The short option's time decay helps offset the long option's time premium.
  • When you want to lower the net cost of options. The sold premium subsidizes the purchased contract.
  • When you are directionally bullish or bearish. Call or put diagonal spreads establish the desired market position.
  • When volatility skew between near and longer-dated options exists. This allows the trader to capitalize on differential mispricing.

In general, diagonal spreads benefit from stable trending in the underlying, as the dual option positions allow you to profit from the persistent directional move.

Diagonal Spread Strategies

There are a few key strategies utilizing diagonal spreads:

Long Diagonal Call Spread

This involves buying a longer-dated, out-of-the-money call option and selling a nearer-term, out-of-the-money call. It is used when moderately bullish on the underlying.

Long Diagonal Put Spread

This involves buying a longer-dated, out-of-the-money put and selling a nearer-term, out-of-the-money put. It is used when moderately bearish on the underlying.

Calendar Call/Put Spreads

This involves selling a near-term at-the-money option and buying a longer-dated at-the-money option of the same type. It benefits from the time decay of the short option.

Diagonal Call/Put Calendar Spreads

This involves selling a near-term in-the-money option and buying an out-of-the-money longer-dated option. It benefits from time decay on the short option.

These spreads allow traders to tailor the strategy to their specific market forecast and risk-reward preferences. The key is aligning the timing of the options with the expected market moves.

How to Set Up a Diagonal Spread

When constructing a diagonal spread, there are a few key steps:

  1. Decide on the market forecast and appropriate strategy (i.e. bullish diagonal call spread).
  2. Choose the two expiration months to use, keeping in mind the forecasted price moves.
  3. Select the strike prices, with the goal of the sold option expiring worthless.
  4. Buy the longer-dated option and sell the nearer-term option.
  5. Consider spreads using the same strike prices or an in/out-of-the-money combination.
  6. Evaluate the net premium paid or received when establishing the spread.
  7. Assess the maximum profit, loss, and break-even points given the strikes.
  8. Manage the position as the expiration dates approach.

Following these steps allows the trader to systematically build the diagonal spread position with their particular goals and risk tolerance in mind.

Tips for Trading Diagonal Spreads

There are some useful tips to keep in mind when trading diagonal spreads:

  • The shorter dated option should expire first to allow the position to roll into just the long option contract.
  • Be aware of assignment risk on the short option leg before its expiration date.
  • Consider tax implications of the short and long term capital gains.
  • Actively manage the spread as the expiration dates approach.
  • Close out or roll the position before the nearer term option expires.
  • Pay close attention to changes in implied volatility over the life of the trade.
  • For calendar spreads, use thinner markets with pricing inefficiencies.
  • With calendar spreads, maximize time decay by using at-the-money strikes.

By following these tips, diagonal spread traders can boost their chances of success.

Final Thoughts

While diagonal spreads are more complex option strategies, they can provide savvy traders with additional ways to profit. By simultaneously buying and selling offsetting options at different expirations, traders can benefit from persistent directional moves, volatility skew, and time decay. Using call and put diagonal spreads allows traders to tailor the strategies to bullish, bearish, or neutral forecasts. Setting up the diagonal spreads methodically and managing them actively can lead to potentially rewarding outcomes. With the proper understanding, diagonal spreads can be an intriguing addition to an option trader's repertoire.

Other Blog Articles