What Is a Diagonal Spread?
A diagonal spread is a modified calendar spread involving different strike prices. It is an options strategy established by simultaneously entering into a long and short position in two options of the same type—two call options or two put options—but with different strike prices and different expiration dates.
This strategy can lean bullish or bearish, depending on the structure and the options utilized.
- A diagonal spread is an options strategy that involves buying (selling) a call (put) option at one strike price and one expiration and selling (buying) a second call (put) at a different strike price and expiration.
- Diagonal spreads allow traders to construct a trade that minimizes the effects of time, while also taking a bullish or bearish position.
- It is called a "diagonal" spread because it combines features of a horizontal (calendar) spread and a vertical spread.
How a Diagonal Spread Works
This strategy is called a diagonal spread because it combines a horizontal spread (also called a time spread or calendar spread), which involves a difference in expiration dates, and a vertical spread (price spread), which involves a difference in strike prices.
The terms horizontal, vertical, and diagonal spreads refer to the positions of each option on an options grid. Options are listed in a matrix of strike prices and expiration dates. Options used in vertical spread strategies are all listed in the same vertical column with the same expiration dates. Options in a horizontal spread strategy, meanwhile, use the same strike prices, but are of different expiration dates. The options are, therefore, arranged horizontally on a calendar.
Options used in diagonal spreads have differing strike prices and expiration days, so the options are arranged diagonally on the quote grid.
Types of Diagonal Spreads
Because there are two factors for each option that are different, namely strike price and expiration date, there are many different types of diagonal spreads. They can be bullish or bearish, long or short, and utilize either puts or calls.
Most diagonal spreads are long spreads and the only requirement is that the holder buys the option with the longer expiration date and sells the option with the shorter expiration date. This is true for both call diagonals and put diagonals alike.
Of course, the converse is also required. Short spreads require that the holder buys the shorter expiration and sells the longer expiration.
What decides whether either a long or short strategy is bullish or bearish is the combination of strike prices. The table below outlines the possibilities:
|Diagonal Calendar Spread Configurations|
|Diagonal Spreads||Diagonal Spreads||Nearer Expiration Option||Longer Expiration Option||Strike Price 1||Strike Price 2||Underlying Assumption|
|Calls||Long||Sell Near||Buy Far||Buy Lower||Sell Higher||Bullish|
|Short||Buy Near||Sell Far||Sell Lower||Buy Higher||Bearish|
|Puts||Long||Sell Near||Buy Far||Sell Lower||Buy Higher||Bearish|
|Short||Buy Near||Sell Far||Buy Lower||Sell Higher||Bullish|
Example of a Diagonal Spread
For example, in a bullish long call diagonal spread, buy the option with the longer expiration date and with a lower strike price and sell the option with the near expiration date and the higher strike price. An example would be to purchase one December $20 call option and the simultaneous sale of one April $25 call.
Typically, these are structured on a 1:1 ratio, and long vertical and long calendar spread results in a debit to the account. With diagonal spreads, the combinations of strikes and expirations will vary, but a long diagonal spread is generally put on for a debit and a short diagonal spread is set up as a credit.
Also, the simplest way to use a diagonal spread is to close the trade when the shorter option expires. However, many traders "roll" the strategy, most often by replacing the expired option with an option with the same strike price but with the expiration of the longer option (or earlier).