By John Summa, CTA, PhD, Founder of OptionsNerd.com
Spreads with Different Months and Different Strikes
Now that we have covered the basic spreads - debit/credit vertical and debit/credit horizontal - taking the next step to a diagonal should be easier. Recall that spreads can be done either as debits or credit spreads, and can be constructed with puts or calls. That said, with a diagonal spread, we are going to take the horizontal time spread and move the long leg to a different strike. That's it! It's easy. Diagonal simply refers to choosing a back-month leg that is not the same as the front-month leg. Figure 1 contains the key relationships in terms of months and legs for our three types of spread constructions - vertical, horizontal and diagonal.
|Figure 1 - Spread types - months and strikes|
To understand diagonal spreads, you first must understand differential time value decay, which we explained in the horizontal spread section of this tutorial. Unlike in a horizontal spread, when we go diagonal there are multiple combinations of possible constructions. A diagonal spread has only two possible strike combinations, which must always be the same. While it is possible to establish an out-of-the-money horizontal spread, the basic dynamic at work in diagonals and horizontals is the same - differential Theta.
Let's view an example of a diagonal call spread using IBM again. In this case, we will construct the diagonal with a credit (there are other possibilities) using puts instead of calls. Suppose we sell an out-of-the-money call at 90 and buy a further out-of-the-money call at 95. And let's say we sell the 90 in September and buy the 95 in October. If we sell the September for 50 and buy the October for 10, we would have the maximum profit at the short strike of 50 when September expires, as can be seen in Figure 2. This is easy to understand. If IBM trades up to the short strike of the diagonal spread and expires at that strike, we retain the entire $50 for selling the September 90 strike.
|Figure 2 - Diagonal call credit spread profit/loss|
At the same time, the October 95 is going to have additional time premium on it as it is presumably now only five points out of the money (recall that when we put this on, IBM was trading at 82.5). Therefore, there also will be a profit on the long October 90 call, even though time premium decay will have taken some value out of the option. Let's say the October 95 now has $30 in premium. Taken together the total position at this point would have made $80 if closed out.
|Figure 3 - Diagonal put credit spread profit/loss|
The advantages of using a diagonal spread for credit spread can be found in the potential gains on the long back-month option. In terms of position Vega, meanwhile, unless you go too wide on the spread between the nearby and back month options, you will have a positive position Vega - which gives you a long volatility trade, just like our horizontal time spreads seen above. What is interesting about the diagonal, however, is that it may begin at neutral or slightly position Vega short (typical if a credit is created when putting it on). But as time value decays on the nearby option, it gradually turns position Vega long. This works particularly well if using puts to construct the spreads because if the stock moves lower, the long option captures the rise in implied volatility that usually accompanies increasing fear surrounding the stock's decline.
When the diagonals are reversed, just as with reversed horizontal spreads, the spread experiences a flip to basically short Vega (loses from rise in volatility) and negative position Theta (loses from time value decay). The trade has the mirror image of potential profitability seen in Figure 2 and Figure 3. Generally, these trades should be constructed mostly with the idea of trying to profit from a quick change in volatility, since the probability of having a big enough move of the underlying is usually quite low.
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