Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
Table of Contents
A diagonal spread is an options trading strategy involving both a long and short position on the same stock, with different strike prices and different expiration dates. It’s a combination of a vertical spread and a calendar spread.
Using this strategy may allow the trader to realize gains early if the stock moves in a direction that’s in their favor. The trader makes two options trades simultaneously — either call options or put options — to take both a bullish and bearish position on the same underlying asset.
Key Points
• Diagonal spreads combine long and short positions on the same stock, using different strike prices and expiration dates.
• This strategy allows early profit if the stock moves favorably.
• Traders may use a long put diagonal spread by buying a longer-term put and selling a shorter-term to express a bearish outlook while offsetting cost through time decay.
• Traders may use a short put diagonal spread by selling a longer-term put and buying a shorter-term put to express a bullish outlook and potentially profit if both options expire worthless.
• Risks include overpaying for the spread and being exposed to market volatility.
Diagonal Spreads Defined
Diagonal spreads are a two-step options trading strategy considered to be an advanced trading tactic. It’s a combination of a calendar spread and a long or short call or put spread. These positions have different expirations and different strikes which spread out diagonally, hence the name of the strategy.
A calendar spread typically involves a trader buying a contract with a longer expiration date while going short on an option with a near-term expiration date with the same strike price. But if two different strike prices are used, this is a diagonal spread.
A diagonal spread is essentially a calendar spread, also referred to as a horizontal spread or a time spread, combined with a vertical spread, because different strike prices are involved.
How Diagonal Spreads Work
A long put diagonal spread involves purchasing a put for some time in the future while selling a put in the short-term. Purchasing an option with a later expiration tends to be more expensive due to its higher time value. On the other hand, the options trader sells the nearer term option with the goal of lowering the cost of the other option. Traders usually use diagonal spreads when they have conviction about a stock’s direction while trying to manage the effects of time decay by collecting near-term premium that decays faster than the longer-term option loses value.
A diagonal bull spread becomes a valuable trade when the price of the stock increases, while a diagonal bear spread increases in value when the stock price decreases.
Diagonal spreads require an in-depth understanding of volatility and timing.
Setting Up a Diagonal Spread
When traders are bullish on a stock, they generally use call options vs. using put options when they’re bearish on a stock.
The most common way to set up a diagonal spread is to buy a back month option (i.e., with more days to expiration) that is in the money. Then, the trader sells a front month (near-term) option contract with a strike price that is out of the money in order to reduce the net cost of the trade and express a directional view.
Setting up a diagonal spread in this manner would constitute a debit spread, which may allow the trader to define their maximum risk upfront while maintaining profit potential if the trade moves in their favor. Some traders may also use credit spread structures depending on their outlook and positioning.
Maximum Loss
When a stock’s price rises, the maximum loss is equal to the premium paid when buying a call. If the stock falls, the maximum loss is the difference between the strike prices adjusted by the option premium paid or received, assuming the long leg remains in place and the short leg is not assigned early.
Maximum Profit
It can be difficult to anticipate what the maximum gain may be since traders can’t know what the back-month option will be trading at when the front-month option expires due to changing volatility expectations. In a long diagonal spread, the stock price must be near the short strike at the time the short option expires for a trade to go in the buyer’s favor — whether using calls or puts.
The max profit potential for a short diagonal call spread is typically limited to the net credit received minus commissions. If the stock price falls below the short call’s strike price, the value of the spread will be close to zero and the credit received may represent a profit.
On the other hand, the max profit scenario of a short diagonal put spread is when the stock price rises above the strike price of the sold higher strike put option, as the value of the spread nears zero and the credit received may represent a profit.
Breakeven Point
The breakeven point can’t be calculated precisely, but it can be estimated. The breakeven price at expiration for a long call is typically below the strike price of the short call. During expiration of a long call, the breakeven point is the stock price at which the premium of the short call is the net credit received for the spread.
Traders cannot predict what the breakeven stock price will be because it depends on market volatility, which can impact the price of the short call.
Diagonal Spread Examples
In one example, a trader is bullish on ABC stock, currently priced at $300. If the front month is January and the back month is February, the trader may want to purchase a $298 strike call with February expiry, which is in the money. Then the trader could sell a $302 strike call with January expiry, which would be out of the money. This would give the trader a four-point wide diagonal spread, with a potential to profit if the stock price approaches the $302 short strike by January expiration and the short call expires worthless while the long call retains value.
In another scenario, a trader is bearish on XYZ stock at a current market price of $129. To set up a diagonal spread, the trader could buy a $132 February put, which would be several dollars in the money. Next, the trader could sell a $126 January put, which would be a few dollars out of the money. This trade would be a six-point wide diagonal spread.
Types of Diagonal Spreads
There are different types of diagonal spread strategies traders can use to pursue their market outlook. Here are several diagonal spreads traders may consider:
1. Long Call Diagonal Spreads
To execute on a long call diagonal spread, traders must buy an in-the-money call option with a longer-term expiration date and then sell an out-of-the-money (OTM) call option with a nearer-term expiration date. Traders can use this advanced options strategy if they are mildly bullish on a stock in the near-term and very bullish in the longer-term. An ideal setup for a long call diagonal spread is during times of low volatility, as sharp price swings can reduce its effectiveness and may even lead to losses if the stock moves beyond both strikes.
2. Long Put Diagonal Spreads
To execute on a long put diagonal spread, traders must buy an in-the-money put option with a longer-term expiration date and then sell an out-of-the-money put option with a nearer-term expiration date that has an out the money strike. Traders typically use long put diagonal spreads to mimic a synthetic covered put position, and to express a bearish outlook on the underlying asset.
3. Short Call Diagonal Spreads
A short call diagonal spread is when traders sell a long-term call with a lower strike price and buy a shorter-term call with a higher strike price. A trader may benefit from a short call option when the price of the underlying asset falls, thus making this a bearish strategy.
4. Short Put Diagonal Spreads
A short put diagonal spread involves selling a longer-term put with a higher strike price and buying a shorter-term put with a lower strike price. This is a bullish strategy, as the trader may benefit if the underlying asset goes up in price, making both options expire worthless and netting the seller the net credit earned at the beginning of the trade.
5. Double Diagonal Spread
A double diagonal spread is when a trader buys a longer-term straddle and sells a shorter-term strangle, a trade that may benefit from time decay and an increase in volatility. Traders setting up a double diagonal are long the middle strike calls and puts, which expire further in the future, and short out-of-the-money call and put options with sooner expiries. The ideal outcome for double diagonals is for the stock to stay between the two OTM strike prices as they approach expiration.
Risks of Diagonal Spreads
The primary risk traders have in diagonal spreads is overpaying to enter the position, which can limit profitability. The maximum risk is capped at the initial debt paid to enter the position. If traders pay too much for their diagonal spreads they may remain unprofitable.
Market volatility can be used to the trader’s advantage when using diagonal spreads, although it can also pose a risk to such trades. Depending on the level of volatility, it can substantially change the price of the option and impact the trader’s profit potential. Diagonal spreads are an advanced trading strategy so traders who are experienced in dealing with volatility may be better positioned to incorporate diagonal spreads in their investment strategy.
The Takeaway
Setting up a diagonal spread correctly is an important part of the profit potential of the strategy, otherwise traders are at risk of losing money. This advanced options trading strategy requires traders to make both long and short trades, either with calls or puts, that have different expiration dates and strike prices. Traders should know these option trades are lined up diagonally from one another in terms of expiration and strike.
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FAQ
What is a diagonal spread?
A diagonal spread is an options strategy that combines long and short positions with different strike prices and expiration dates. It blends elements of both calendar and vertical spreads.
What are the risks of diagonal spreads?
Risks include overpaying for the spread, sensitivity to volatility changes, and inaccurate market timing. These factors may reduce potential profits or increase potential losses if the trade moves against expectations, though losses are typically limited to the net debit paid to enter the position.
What is the difference between a bull call spread and a diagonal spread?
A bull call spread uses two call options with the same expiration but different strike prices. A diagonal spread also uses different strikes, but the contracts expire on different dates.
What is the difference between a calendar spread and a diagonal spread?
A calendar spread uses options with the same strike price and different expiration dates. A diagonal spread changes both the expiration date and the strike price, adding a directional element.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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