What Is a Diagonal Spread?
A diagonal spread 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. Typically these structures are on a 1 x 1 ratio.
This strategy can lean bullish or bearish, depending on the structure of the options.
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 represents the difference in expiration dates, with a vertical spread, or price spread, which represents the difference in strike prices.
The names 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. Therefore, 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 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 puts or calls.
Most diagonal spreads refer to 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 call strategies and put strategies 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 Spreads||Diagonal Spreads||Expiration Dates||Expiration Dates||Strike Price||Strike Price||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 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 setup 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).