What Is a Diagonal Spread and How Does It Work?

Options trading strategies offer an efficient way for market-savvy investors to accumulate wealth through consistent profits. Some of these strategies are more complex than others and require a thorough understanding for their implementation. The diagonal spread strategy is an advanced options trading strategy that uses a calendar spread with different strike prices. 

Keep reading till the end to know everything about diagonal spreads and how they are used. 

What Is the Diagonal Spread Strategy?

A diagonal spread is an options trading strategy that integrates vertical and horizontal spreads. This strategy involves buying a call option at a strike price and expiration date and selling another option at a different strike price and expiration date. This option position allows traders to simultaneously enter into long and short positions of two options of the same type. 

For options trading, people need to check a matrix of strike prices and expiry dates of separate options called options chains. In a diagonal spread, one needs to move diagonally on this table between two columns at extreme ends. This contributes to its name.

How Does a Diagonal Spread Work?

Like horizontal spreads, diagonal spreads involve the use of different expiration prices. It also involves separate strike prices like vertical spreads. This spread strategy gets its name from the position of strike prices on the spread. 

As an option on diagonal spread has separate expiration dates and strike prices, they are arranged diagonally on the quote grid. Options that are used for vertical strategies are listed in the same vertical column with same expiration dates. 

On the other hand, options of horizontal spread have the same strike price and are listed horizontally with different expiration dates. 

To explain the workings of a diagonal spread, let’s consider the illustration below:

A trader opts for a bullish long call diagonal spread. To go ahead with their trading strategy, they would need to purchase options with the farthest expiration dates and the lowest strike prices. Furthermore, they need to sell the options with shorter expiration dates and higher strike prices. 

By purchasing a call option with ₹1,640 strike price for December and selling another call option at ₹2,050 in April, the trader will stand to make a profit. With this, they will take a long position in the short term and a bearish position over the longer term.

It is important to note that traders typically use a short diagonal spread in a 1:1 ratio with one long vertical spread and a horizontal spread. While the actual combination may be different, long diagonal spreads are used for debits while short spreads are used for credit.

When Can a Trader Use a Diagonal Spread?

Usually, seasoned traders use this trading strategy when they are bullish on stocks in any asset class. A trader can opt for a diagonal spread under the following situations:

• Neutral-to-bullish action within the first expiry date
• Neutral price action of an asset class within the second expiry date

Furthermore, you can also use a diagonal spread call strategy when you are bearish or neutral on an asset class you have picked. Here are the situations when you can use a short diagonal spread:

• Neutral-to-bearish price action within the first expiry date 
• Neutral price action in an asset class within the second expiry date

What Are the Benefits of Trading with a Diagonal Spread? 

Following are some of the noteworthy benefits of trading using the diagonal spread strategy.

• Traders using this strategy can make profits from time decay.
• The position one enters using this strategy is considerably cheaper than usual covered calls. They also come with lower risk levels.
• A diagonal trading strategy also offers flexibility to traders to choose from various options. This facility is not available with many other option strategies.
• Its return percentage is also more than traditional covered calls.

What Are the Problems Involved with Diagonal Spreads?

The following are some of the disadvantages of using the diagonal spread strategy:

• This strategy is appropriate only for seasoned traders as it involves options with multiple expiry dates.
• The strategy can be difficult to manage in practice as shorter positions are vulnerable to the risk of a sudden increase in volatility. 
• You cannot accurately calculate the breakeven points, maximum potential profits and risk of losses. 

Final Words

Despite being a more promising strategy than vertical and horizontal spreads, diagonal spreads are quite complicated for beginners. Only seasoned investors having clear knowledge of the stock market should choose this strategy. For these traders, the diagonal spread strategy offers a flexible and low-cost investment method with limited risks.

Frequently Asked Question