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In options trading, creating spreads is a fundamental technique. Spreads are positions taken simultaneously in options that have various characteristics but are based on the same underlying asset.
Spreads can be broadly classified as either horizontal or vertical.
Options with multiple expiration dates and the same strike price are combined to form a horizontal spread, sometimes referred to as a calendar spread. Conversely, a vertical spread consists of options with distinct strike prices but the same expiration date. This kind concentrates on the underlying asset’s price change.
From these two, the diagonal spread strategy is derived. It combines the variable contract durations of the calendar spread with the broad strike price selection of the vertical spread.
Continue reading to learn more about how you may use this approach to your advantage when trading.
What is a diagonal spread?
A diagonal spread involves taking both a long and a short position on options of the same class, yet at different strike prices and expiration dates.
Options, by their nature, offer a spectrum of strike prices and expiry dates, creating a matrix that traders navigate to structure their positions. When you visualise this matrix, the arrangement of options used in a diagonal spread will appear diagonally across it, hence the name.
Understanding diagonal spread
How to manage diagonal spreads here when you set up a long spread? You’re essentially making two moves at once:
- Long position: You purchase an option with an extended period of expiration. The strike price of this option varies as well.
- Short position: You sell another option that will expire sooner. This option, too, has its own strike price, different from the first one.
Your aim with a diagonal spread is to make money from the difference in time and price conditions you have set up with these two options. You want the market to move in your favour i.e. in-the-money (ITM) which makes your long option increase in value while the short option doesn’t cost you too much as it will expire soon.
- If things go well, the short option expires, and you get to keep the money you made when you first sold it.
- Your long option, the one you bought for later, still has time to grow in value. This extra time value can translate to additional profit if the price keeps moving favourably even after the short option expires.
- If the market doesn’t move as expected, out-of-the-money (OTM) and both options start losing value, you don’t just have to sit there and watch. Because the option you bought expires later, you have some time to adjust your strategy.
Types of diagonal spread
Diagonal spreads in options trading combine different strike prices and expiration dates, offering strategies for both bullish and bearish market outlooks.
There are two main types based on expiration: long and short diagonal spreads.
- Long diagonal spreads involve buying an option with a longer expiration and selling one with a shorter expiration.
- Short diagonal spreads conversely involve buying an option with a shorter expiration and selling one with a longer expiration.
They are dependent on the call and put options as well.
- Diagonal call spreads are created by buying a later-expiration call option and selling an earlier-expiration call option at a higher strike price. With this strategy, the price of the underlying asset is expected to rise, and the goal is to profit from this growth.
- Diagonal put spreads are intended to generate income in the event that the price of the underlying asset declines more than anticipated. In this approach, an earlier expiration date put option is sold at a lower strike price and a later expiration date put option is purchased.
Determining whether a diagonal spread is long or short, call or put depends on the strike prices of the involved options and their expiration dates. The market outlook—bullish or bearish—is also a crucial deciding factor.
| Call | Put | |||
| Long | Short | Long | Short | |
| Market outlook | Bullish | Bearish | Bearish | Bullish |
| Nearer Expiration Option | Sell Near | Buy Near | Sell Near | Buy Near |
| Longer Expiration Option | Buy Far | Sell Far | Buy Far | Sell Far |
| Strike Price 1 | Buy Lower | Sell Lower | Sell Lower | Buy Lower |
| Strike Price 2 | Sell Higher | Buy Higher | Buy Higher | Sell Higher |
Diagonal calendar spread configurations
Diagonal spread example
Suppose the Nifty50 is at 17,200 and you’re bullish. You set up a call diagonal spread as follows:
- Sell call option: Strike price of 17,250 expiring on 15 October for a ₹210 premium.
- Buy call option: Strike price of 17,150 expiring on 29 October for a ₹280 premium.
Diagonal spread calculation:
Net premium: Results in a net debit of ₹70.
Breakeven: 17,250 (short call strike) – ₹70 = 17,180.
Max loss: ₹3,500 (Net premium * lot size of 50).
Max profit: ₹1,500 [(100 difference in strikes – 70 net premium) * lot size].
This approach aims for a profit if Nifty50 exceeds 17,250 by 15 October, demonstrating a strategic use of expiration and strike differences in a bullish market.
Bottomline
The diagonal spread offers a dynamic trading strategy, blending the timing advantage of calendar spreads with the strike price flexibility of vertical spreads. Unlike the singular focus on price movement in a vertical spread, a diagonal spread vs vertical spread allows for nuanced market predictions, leveraging time and price for potential gains.
FAQs
When a trader uses a diagonal call spread strategy, they buy a call option with a longer expiration date and a lower strike price and sell a call option with a shorter expiration date and a higher strike price. This strategy is best suited for an optimistic outlook on the underlying asset since it seeks to profit from both the short-term option’s time decay and the long-term option’s possible growth in value.
Diagonal spreads can be profitable when market conditions align with the strategy’s expectations of directional movement and volatility. They leverage the time decay of short-term options and the value potential of long-term options. Success relies on accurate market predictions and effective management of the positions. While diagonal spreads offer a strategic approach to trading, outcomes vary based on market dynamics and the spread’s execution.
Diagonal spreads carry risks such as misjudging the market’s direction, leading to potential losses if the underlying asset doesn’t move as expected. Volatility changes can also impact the spread differently, affecting profitability. The complexity of managing two options with different strike prices and expiration dates adds to the challenge, requiring timely adjustments to mitigate losses. Additionally, liquidity issues for the options, especially the longer-dated ones, can complicate executing trades at favourable prices.
A diagonal spread involves buying and selling two options of the same type (calls or puts) with different strike prices and expiration dates. Typically, you buy a long-term option at a lower strike price and sell a short-term option at a higher strike price. This strategy aims to profit from the time decay of the short-term option and the potential price movement of the underlying asset favouring the long-term option.
Whether diagonal spreads are better than vertical spreads depends on your trading goals and market outlook. Diagonal spreads offer advantages in markets where you anticipate a gradual move in the underlying asset, allowing you to benefit from time decay and volatility changes. Vertical spreads are simpler and may be preferable in markets with a clearer direction. Diagonal spreads provide flexibility and potential for income through time decay, while vertical spreads focus on pure directional plays with potentially quicker outcomes.
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