Diagonal Spreads. Part 1. Introduction

Single and Double Diagonal Spreads

Diagonal Spread
A = strike for short option; B= strike for long option. Source: OptionsPlaybook.com

This article concerns an 'advanced topic' -- and that means readers should understand basic .

A diagonal spread contains two legs (i.e., two different options). Both are calls or both are puts.

Buying a diagonal spread is equivalent to owning each of the following:

  • One credit spread (Option bought is farther OTM than option sold)
  • One calendar spread.(Option bought expires after the option sold; Both options have the same strike price))

     

    Example: It is mid-September, XYZ is $75 per share,  and a trader wants to initiate a 4-lot XYZ Nov 90/Oct 80 diagonal call spread:

    Long  4 XYZ Nov 90 calls
    Short 4 XYZ Oct  80 calls

     

    This call diagonal spread is equivalent to owning 4-lots of:

    • The XYZ Nov 80/90 call credit spread and
    • The XYZ Nov/Oct 90 call calendar spread
    • Although not always true, this position is generally opened with the trader collecting a net credit (i.e., net cash is collected because the short option is priced higher than the long option). 

     

    Proof of equivalency
    +4 Oct  90 calls
    -4  Oct 80 calls     The credit spread

    +4 Nov 90 calls
    -4  Oct 90 calls     The calendar spread

    Add the positions:
    The Oct 90 calls disappear (we bought four and sold four)
    Position is: Long 4 Nov 90 calls and short Oct 80 calls. 

     

    Important Note: 

    When trading a diagonal spread, ALWAYS take the efficient road. That means buy the diagonal spread using one spread order.

    Do not trade the credit spread and then the calendar spread as two separate orders. The two-trade example was only used to demonstrate that the positions are equivalent to each other. When trading we incur and must pay commissions, so we want to  minimize the number of option contracts traded. As an aside, I hope it is obvious that there is no reason to buy -- and then sell -- the same option just to get the position wanted.

    It is preferable to buy the desired final position in a single transaction.

     

    Why Choose This Strategy?
    The diagonal spread is appropriate for traders with a market bias. Let's look at the above example:

    By being short the Oct 80 calls, the trader has risk of loss when the stock moves higher. This idea is confirmed when we look at the accompanying risk graph. By owning the Nov 90 calls, the trader's upside loss is capped. In other words, if XYZ were to rally to $100 per share, the value of the Oct 80 calls would increase dramatically (to $20 or perhaps a small amount higher). Although the  Nov 90 calls would not rise as dramatically, they would gain enough value to establish a maximum possible value for the spread. that in turns limits the trader's potential loss. That maximum loss is the difference between the strike prices, or $10 * 100, or $1,000 (minus the premium collected).

    When the market moves lower, risk of losing money declines. The profit potential becomes the original cash collected plus any remaining value in the longer-dated (Nov 90) call once the shorter-dated (Oct 80) call expires.

    An even higher profit is earned when the stock drifts higher and approaches, but never reaches $80 in this example.

    Once again, the trader covers the Oct $80 call at a low price, or allows it to expire worthless. With the stock priced in the upper seventies (and expiration has arrived), that Nov 90 call is worth more than when the stock is lower. That means the profit potential is greater.

    But do not misunderstand. If the stock does move higher and does approach the strike price ($80) of the short option, the risk of losing money increases significantly. Sure it is terrific when expiration arrives and the stock is $79.50. But waiting for that to happen is a big mistake because the stock does not have to do what you prefer. If it soars to $84 or $86, you will be very unhappy with the outcome. Thus, when collecting a cash credit for a diagonal call spread, be happy when the underlying stock dips lower. Your goal is to earn profits.

    It is not to wish for miracles so that you can earn the maximum possible reward.

    Thus, the diagonal call spread is for traders with a slightly bearish or neutral market bias. Similarly, the diagonal put spread is for traders with a neutral or slightly bullish market bias.

    See the risk graph for a generic diagonal spread:

     

    Takeaway: Because the diagonal spread contains an embedded credit spread, the only rationale for choosing the diagonal over that credit spread is a belief that owning the calendar spread will be profitable -- and that generally requires to rise or hold steady.

     

    Double Diagonal Spread
    A double diagonal spread is a position consisting of one diagonal call spread and one diagonal put spread, using options on the same underlying asset. The call options expire at the same time as the put options.