The diagonal spread revolves around buying and selling options of the same kind (but with different strike prices and expiration dates) at the same time. This strategy is designed to leverage the benefits found in both vertical and calendar spreads.
What makes the diagonal spread appealing is its flexibility, granting traders the ability to hold multiple positions and potentially acquire options at a reduced cost.
Nevertheless, just like all options trading strategies, the diagonal spread comes with its own set of risks. Traders can incur losses if the underlying security doesn’t perform as expected.
This article explores all you need to know about diagonal spread options strategy, including how it works and its risks.
What is Diagonal Spread and How Does it Work?
A diagonal spread is a unique options trading strategy that combines elements of both a bull call spread and a bear put spread, while also incorporating aspects of a calendar spread.
The strategy involves merging a bullish call spread with a bearish put spread. In the bullish segment, an investor buys a call option with a longer expiration date compared to the call option they sell. For instance, they might buy a call with an expiration in January and sell a call with a closer expiration in September, both at the same or lower strike price.
For the bearish put spread part of the strategy, the investor sells a put option with the closer expiration month and buys a put option with the more extended expiration month, both at the same strike price.
Following our example, they could sell a September put and buy a January put at the same strike. By intertwining these two spreads, the trader establishes a diagonal spread position.
In essence, a diagonal spread allows investors to create a dynamic position that benefits from both upward and downward price movements, offering a versatile approach to navigating the complexities of the options market.
READ: What You Need to Know About Long Call Option Strategy
Benefits of Diagonal Spread
The diagonal spread strategy offers a way to create positions that balance generating income, maintaining upside exposure, and controlling downside risk.
One of the key benefits of the diagonal spread is its ability to allow traders to participate in potential price moves of the underlying asset while implementing defined risk parameters.
By using both calls and puts with staggered expiration dates, the maximum possible loss is limited to the debit paid to open the trade. This feature is beneficial for traders seeking downside protection instead of the unlimited risk associated with other strategies.
Moreover, the structure of incorporating longer-dated long options gives the position more time to develop before facing significant time decay pressures.
Unlike short-term spreads that are vulnerable to rapid theta decay as expiration approaches, the staggered expirations of a diagonal spread help mitigate this limitation.
This feature makes the trade more suitable for longer-term holding, thereby reducing risk through an extended time horizon.
Another reason why diagonal spreads are significant is their dual role in generating income and providing a moderate bullish bias within a portfolio. By selling premiums through short strikes, upfront income is collected, thereby reducing the net entry price and increasing the probability of profitability.
Simultaneously, the long strikes allow participation if the market surpasses the short positions. This dual function in both generating yield and retaining upside exposure diversifies the portfolios compared to straightforward long stock positions.
The income generation aspect is also meaningful because it works to decrease the net cost basis, potentially leading to trade success even in the face of modest declines or flat price action in the underlying stock over the life of the positions.
This adaptability to neutral markets sets diagonal spreads apart from strategies relying solely on directional assumptions, as the premium sold acts as a buffer against sideways prices.
More so, the staggered placement of strikes at varying distances from the current price embeds implicit leverage in the position without taking on disproportionate risk. This results in less capital being tied up compared to an equivalent shares-based position, amplifying any profitable moves that may occur.
The inclusion of long options allows for participation beyond what a typical sold premium position entails.
The flexibility of diagonal spreads allows traders to tailor their risk/reward priorities. Different combinations of long and short strikes, as well as expiration dates, can drastically shift the risk and reward profile, making the strategy highly customizable to individual traders’ objectives and market outlooks in a way that cannot be replicated by isolated legs.
Diagonal Spread Options Strategy Example
A simple illustration of the diagonal spread option involves buying a $10 option that expires on July 10, 2023, while simultaneously selling a $15 option expiring on February 10, 2023.
In this case, the trader is acquiring an option with a more extended expiration date and a lower strike price while concurrently selling an option with a closer expiration date and a higher strike price.
Diagonal Spread Strategy Chart
The diagonal spread chart below illustrates the different strike prices:
As shown in the chart, the strike prices are S-1 (strike for short option) and S-2 (strike for the long option).
READ: A Beginner’s Guide to Long Put Option Strategy
What are the Risks of Diagonal Spread?
While diagonal spreads offer flexibility and strategic advantages, they come with their risks. Traders need to be aware of these potential pitfalls before implementing this strategy.
Here are some key risks associated with diagonal spread options strategies:
Price volatility
Diagonal spreads are sensitive to changes in the underlying asset’s price. Sharp and unexpected price movements can impact the profitability of the strategy.
Directional risk
If the market moves significantly against the expected direction, it can lead to losses, especially if the short leg is threatened by being in-the-money.
Negative theta
Diagonal spreads involve selling options with closer expiration dates and buying options with longer expiration dates. The strategy benefits from time decay, but if the market doesn’t move as expected, the time decay advantage may be offset by losses in the long leg.
Implied volatility risk
Diagonal spreads are affected by changes in implied volatility. If volatility increases, the value of both legs may rise, impacting potential profits.
On the other hand, a decrease in volatility may reduce the overall premium, affecting the strategy’s effectiveness.
READ: What Options Traders Need to Know About Implied Volatility
Lack of liquidity
Some options may lack liquidity, making it challenging to execute trades at desired prices. This can lead to wider bid-ask spreads and increased transaction costs.
Capital requirements
Diagonal spreads may tie up significant capital because they involve both buying and selling options. Traders need to ensure they have sufficient capital to meet margin requirements.
Conclusion
Executing the diagonal option spread strategy might seem straightforward, but effectively managing it can be challenging. The short option position is susceptible to sudden increases in implied volatility. However, as this strategy is risk-defined, the potential drawdowns and limits are predetermined. Unlike a direction-neutral strategy, the diagonal spread allows traders to capitalize on a prevailing trend. They can achieve this by establishing credit spreads, effectively minimizing the cost of capital. The credit spread usually results from selling At-the-Money options, which carry the highest extrinsic value. Therefore, it’s recommended to take short positions in options with a near-month expiry.
This strategy can be applied across various time series, spanning from near to far months or near to the subsequent months. By strategically deploying the diagonal spread, traders can navigate market trends and effectively manage their positions.