Diagonal Spreads

A diagonal spread is a neutral trading strategy in options or futures contracts that involves buying and selling options (or futures) with different strike prices and different expiration dates. It’s a more advanced strategy than simple vertical spreads or calendar spreads, combining elements of both. Diagonal spreads are often used when a trader has a slightly directional, but relatively low-conviction, view on the underlying asset. They aim to profit from both time decay and a modest price movement. This article will cover the mechanics, variations, risks, and benefits of diagonal spreads, geared towards beginners.

Understanding the Components

A diagonal spread is constructed by simultaneously:

Buying a long-term option (either a call option or a put option).
Selling a short-term option (a call or put, potentially the same type as the long option).

The key difference from other spread strategies is that the expiration dates are *different*, and the strike prices can also be different. This creates a diagonal line on an options chain payoff diagram, hence the name.

Types of Diagonal Spreads

There are four primary types of diagonal spreads, based on the type of options used:

Long Call Diagonal Spread: Buy a long-dated call option and sell a short-dated call option. This is used when expecting a moderate upward price movement.
Long Put Diagonal Spread: Buy a long-dated put option and sell a short-dated put option. This is used when expecting a moderate downward price movement.
Short Call Diagonal Spread: Sell a long-dated call option and buy a short-dated call option. This is used when expecting the price to remain stable or decline slightly.
Short Put Diagonal Spread: Sell a long-dated put option and buy a short-dated put option. This is used when expecting the price to remain stable or rise slightly.

Mechanics and Payoff

Let's consider a Long Call Diagonal Spread as an example.

Suppose the underlying asset is trading at $100. A trader believes it will move moderately higher. They might:

Buy a call option with a strike price of $100 expiring in 6 months for a premium of $8.
Sell a call option with a strike price of $100 expiring in 1 month for a premium of $3.

The net cost of this spread is $5 ($8 - $3).

Profit Potential: Unlimited, but typically capped. The longer-dated call benefits from price increases, while the short-dated call limits the profit if the price rises dramatically before the short option expires.
Maximum Loss: Limited to the net debit paid ($5 in our example).
Breakeven Point: The breakeven point is complex to calculate precisely and depends on the time to expiration and the implied volatility of both options. It is not simply the strike price plus the net debit.

The profit or loss depends on the price of the underlying asset at the expiration of *both* options. The short-dated option will expire first, potentially impacting the payoff of the long-dated option.

Why Use a Diagonal Spread?

Flexibility: Diagonal spreads offer more flexibility than simple spreads. You can tailor the strike prices and expiration dates to a specific outlook.
Time Decay Benefit: The short-dated option decays faster, which is beneficial if the trader's view is correct and the price moves as expected. This relates to the concept of theta.
Reduced Cost: Selling the short-dated option helps offset the cost of buying the long-dated option.
Directional View with Limited Risk: They allow traders to express a slight directional bias while limiting their potential loss.
Volatility Play: Diagonal Spreads can be used to profit from changes in implied volatility. A rise in volatility is generally beneficial for long option positions.

Risks and Considerations

Complexity: Diagonal spreads are more complex to understand and manage than simpler strategies.
Early Assignment Risk: The short-dated option can be assigned at any time before expiration, particularly if it goes significantly in-the-money. This can create unexpected obligations.
Multiple Expiration Dates: Managing two different expiration dates requires careful monitoring and potential adjustments.
Liquidity: Some diagonal spread combinations may have limited liquidity, making it difficult to enter or exit the position at a favorable price.
Gamma Risk: The spread's sensitivity to price changes (its gamma) can vary significantly.
Delta Hedging: Managing the delta of the spread (its sensitivity to direction) might necessitate delta hedging strategies.

Adjustments

Diagonal spreads often require adjustments as the expiration of the short option nears. Common adjustments include:

Rolling the Short Option: Closing the short-dated option and opening a new short-dated option with a later expiration date.
Closing the Spread: Closing both the long and short options to realize a profit or limit a loss.
Converting to a Vertical Spread: Adjusting the strike price of the long option to create a vertical spread.