What is a Diagonal Spread, and How Does It Work?

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A diagonal spread is a calendar spread customised to include different strike prices. An options strategy is constructed by simultaneously taking a short and long position in two options of the same kind (two put options or two call options), but with different strike prices and expiration dates, and then exiting the position.

Based on the structure of the approach and the options that are used, this strategy might have a bullish or bearish bias.

How is a Diagonal Spread Constructed?

It is referred to as a diagonal spread because it combines two spreads: a horizontal spread (also called calendar spread or time spread), which involves a difference in expiry dates, and a vertical spread (also price spread), which involves a difference in strike prices. This strategy is also known as a diagonal spread.

Options are listed as a matrix of strike prices and expiry dates, with each option listed in a different column. The phrases horizontal, vertical, and diagonal spreads refer to the placements of each option on an options grid, and they are used to describe the spreads between them. The options employed in vertical spread strategies are all shown in the same vertical column with the exact expiration dates, making it easy to identify which options are being used.

However, options in a horizontal spread strategy have different expiration dates, but they have the same strike price as the options in the previous approach. As a result, the selections are displayed on a calendar in a horizontal format.

Because the strike prices and expiration days of the options used in diagonal spreads differ, they are positioned diagonally on the quotation grid when traded.

Types of Diagonal Spreads

The fact that two parameters are distinct for each option, namely the strike price and the expiration date, results in many various forms of diagonal spreads. They might be bullish or bearish, long or short, and use either puts or calls to make predictions.

The majority of diagonal spreads are long spreads. The only need is for the holder to buy the option with the more extended expiry date and sell the option with the shorter expiration date to be profitable. Call diagonals are just as effective as put diagonals in this situation.

There is, of course, also a requirement for the converse. When using a short spread, the holder must purchase the shorter expiration and sell the more prolonged expiration.

The combination of strike prices determines whether a long or short strategy is bullish or bearish, which is the deciding factor. In the following table, you can see the many options:

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

An illustration of a Diagonal Spread

A bullish long call diagonal spread, for example, would consist of purchasing the option with the most extended expiration date and a lower strike price and selling the option with the shorter expiration date and a higher strike price. For example, purchasing one December $20 call option and simultaneous sale of one April $25 call option would be a good illustration.

Special Considerations should be taken into account.

A short diagonal spread is typically used for credit when using diagonal spreads in trading. They are usually constructed in a 1:1 ratio, and a lengthy vertical spread and a long calendar spread result in a debit to the customer’s account. Although the exact combinations of strikes and expirations will vary, a long diagonal spread is typically used for debit.

Aside from that, the most straightforward approach to using a diagonal spread is to close off the deal when the shorter option expires. In practice, though, many traders “roll” their strategies by swapping out an expired call for an option with the same strike price but with the expiration of a more extended option (or earlier).