Diagonal spread

What Is Diagonal Spread?

A diagonal spread is an advanced options strategy that involves simultaneously buying and selling two options of the same type (both calls or both puts) on the same underlying asset, but with different strike prices and different expiration dates. This multi-leg options strategy falls under the broader category of options trading and is designed to capitalize on anticipated movements in the underlying asset's price, while also leveraging the effects of time decay and changes in implied volatility. Typically, the longer-dated option is bought, and the shorter-dated option is sold, creating a combination that can be either a net debit or a net credit position, depending on the specific strike prices and the time to expiration.

History and Origin

The concept of options, giving the right but not the obligation to buy or sell an asset, dates back to ancient times, with early forms mentioned by Aristotle. However, standardized options contracts, which made complex strategies like the diagonal spread widely accessible, are a relatively modern invention. The modern era of options trading began with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. The CBOE was the first exchange to offer standardized options trading, providing a transparent marketplace with centralized clearing for these financial derivatives.¹³,¹²,,¹¹ This standardization, coupled with the development of sophisticated option pricing models, paved the way for more intricate strategies like the diagonal spread to be developed and traded by investors and speculators. The ability to combine options with varying maturities and strike prices allowed for more nuanced risk-reward profiles, moving beyond simple long option or short option positions.

Key Takeaways

• A diagonal spread combines options with different strike prices and different expiration dates, typically buying a longer-dated option and selling a shorter-dated one.
• It can be constructed using either call options or put options.
• The strategy aims to profit from moderate price movement in the underlying asset, with the potential to benefit from time decay of the shorter-dated option.
• Risk and reward profiles vary significantly based on the specific strike prices, the width of the spread, and the time difference between expirations.
• Adjustments may be necessary as the shorter-dated option approaches expiration.

Formula and Calculation

The primary "formula" for a diagonal spread relates to its net cost or credit. When establishing the position, the trader simultaneously buys one option and sells another. The difference in their respective options premium determines whether the strategy is a debit spread or a credit spread.

Net Cost / Credit = Premium Paid for Long Option – Premium Received for Short Option

• If the result is positive, it's a net debit.
• If the result is negative, it's a net credit.

For example, if an investor buys a longer-dated call option for $5.00 and sells a shorter-dated call option for $2.00, the net debit for the diagonal spread would be:

The maximum profit and loss calculations for a diagonal spread are more complex as they depend on the underlying asset's price at both expiration dates and the implied volatility at the time the shorter-dated option expires.

Interpreting the Diagonal Spread

Interpreting a diagonal spread involves understanding its sensitivity to various market factors, particularly the underlying asset's price movement, time decay, and changes in volatility. The strategy's profitability is often linked to the behavior of the theta (options greek) and vega (options greek) of the combined positions.

The bought, longer-dated option generally has more vega and less theta decay than the sold, shorter-dated option. This means the overall position can be sensitive to changes in volatility, often benefiting from an increase in volatility if it's a debit spread, and benefiting from time decay of the sold option. The goal is often for the underlying asset to move favorably while the shorter-dated option's value erodes quickly, allowing it to be bought back for a lower price or expire worthless. The delta (options greek) of the overall spread indicates its directional bias, which can change as the underlying price moves.

Hypothetical Example

Consider an investor who believes Stock XYZ, currently trading at $100, will experience moderate upward movement over the next few months. They decide to implement a diagonal call spread:

1. Buy a longer-dated call option: The investor buys a Stock XYZ January 100 Call option with a strike price of $100, expiring in six months, for an options premium of $7.00. This is their long option leg.
2. Sell a shorter-dated call option: Simultaneously, the investor sells a Stock XYZ October 105 Call option with a strike price of $105, expiring in three months, for an options premium of $2.50. This is their short option leg.

Initial Investment: The net debit for this diagonal spread is $7.00 (paid) - $2.50 (received) = $4.50. This is the maximum potential loss if the stock falls significantly or stays below the sold strike.

Scenario 1: Stock XYZ rises moderately to $107 by October expiration.
The October 105 Call option expires in-the-money. The investor might buy back the October 105 call to close the short leg or allow assignment. The January 100 Call option, which is longer-dated and now deeper in-the-money, retains significant value. The investor can then decide whether to sell the January 100 Call, hold it, or roll the short leg to a new expiration. If the October 105 call is bought back for $2.00, and the January 100 call is sold for $9.00, the overall profit could be calculated.

Scenario 2: Stock XYZ stays below $105 by October expiration.
The October 105 Call option expires worthless, and the investor keeps the $2.50 premium from selling it. The January 100 Call option retains some value based on time remaining and implied volatility. The investor can then decide what to do with the remaining long call, potentially selling it or letting it expire.

Practical Applications

Diagonal spreads are versatile tools used in various financial scenarios within portfolio management and risk management strategies.

• Income Generation: Investors can use diagonal spreads to generate income by consistently selling shorter-dated, out-of-the-money options against a longer-dated, in-the-money or at-the-money option. As the shorter-dated options expire, the premium collected contributes to the overall return.
• Leveraging Time Decay: A key aspect of the diagonal spread is taking advantage of time decay. Shorter-dated options lose value due to time decay faster than longer-dated options, allowing the sold leg to erode in value more rapidly.
• Capitalizing on Volatility Shifts: Depending on their construction, diagonal spreads can be structured to benefit from either increases or decreases in volatility. For instance, a debit diagonal call spread often benefits from a rise in implied volatility, particularly on the long, front-month leg.
• Targeted Price Range Trading: Traders can set up diagonal spreads to profit if the underlying asset trades within a specific price range by the first expiration, while maintaining upside or downside potential with the longer-dated option.
• Strategic Adjustments: When the shorter-dated option nears expiration, it can be "rolled" to a new strike price or expiration date, allowing the investor to manage the position over a longer period without completely closing it. This flexibility is a significant advantage in dynamic market conditions, which are tracked by exchanges like Cboe Global Markets, which publishes daily market statistics on options volume and open interest.,
  ^{10
  9}## Limitations and Criticisms

Despite their versatility, diagonal spreads come with inherent limitations and criticisms that investors must understand. The complexity of these multi-leg strategies makes them more challenging to manage compared to simpler long or short option positions.

• Complexity: Managing a diagonal spread requires a good understanding of various option greeks (delta (options greek), gamma (options greek), theta (options greek), vega (options greek)) and their interplay, as well as constant monitoring of the underlying asset's price and implied volatility. The profit and loss profile is not linear and can be highly sensitive to precise timing and price movements.
• Capital Requirements and Margin: While some diagonal spreads can be credit spreads, many are debit spreads, requiring upfront capital. Even credit spreads may require significant margin requirements, which can tie up capital and lead to margin calls if the position moves unfavorably. Investors should consult the Options Disclosure Document (ODD) provided by the Options Clearing Corporation (OCC) for detailed information on the risks and requirements associated with options trading, including complex strategies.,,⁸,
  ⁷*⁶ Limited Profit Potential: While offering a balanced risk-reward, diagonal spreads often have capped profit potential, especially if the shorter-dated option expires in-the-money and the long option needs to be managed or closed.
• Difficulty in Adjustment: Adjusting a diagonal spread can be challenging and costly, potentially leading to increased transaction fees and further complicating the position. Mistakes in adjustments can amplify losses.
• Volatility Risk: While sometimes used to profit from volatility, unexpected changes in volatility can significantly impact the profitability of a diagonal spread, potentially more so than simpler strategies. Academic research often highlights the complexities and challenges of accurately modeling and predicting volatility for option pricing.,,⁵,⁴,^{3
  2
  1}## Diagonal Spread vs. Calendar Spread

The diagonal spread is often confused with the calendar spread due to their shared use of options with different expiration dates. However, a key distinction lies in their strike prices.

In essence, a calendar spread is a more purely time-decay-focused strategy, where both options have the same strike price, and the profit comes from the faster decay of the nearer-term option. A diagonal spread introduces an additional layer of complexity and potential profit by utilizing different strike prices, allowing for a directional component while still leveraging time decay. This difference in strike prices means the diagonal spread's profit/loss profile can be more tailored to a specific price target for the underlying asset.

FAQs

What is the maximum profit for a diagonal spread?

The maximum profit for a diagonal spread is not easily determined by a simple formula because it depends on the underlying asset's price at the expiration of the shorter-dated option and the value of the longer-dated option at that point, which is influenced by its remaining time to expiration and implied volatility. Typically, the maximum profit is realized if the underlying asset is near the strike price of the long option at the expiration of the short option.

Is a diagonal spread a bullish or bearish strategy?

A diagonal spread can be either bullish or bearish, depending on whether it is constructed using call options or put options, and the relative strike prices chosen. For example, a "diagonal call spread" (buying a longer-dated, lower-strike call and selling a shorter-dated, higher-strike call) is typically a moderately bullish strategy. Conversely, a "diagonal put spread" (buying a longer-dated, higher-strike put and selling a shorter-dated, lower-strike put) is generally a moderately bearish strategy.

How does time decay affect a diagonal spread?

Time decay, or theta, is a crucial factor for diagonal spreads. The shorter-dated option that is sold typically experiences a faster rate of time decay than the longer-dated option that is bought. This difference in decay rates is often a primary source of profit for the strategy, as the value of the sold option erodes more quickly, allowing the investor to potentially buy it back for less or let it expire worthless.

What is the breakeven point for a diagonal spread?

Unlike simpler options strategies, a diagonal spread typically has two breakeven points due to the two different strike prices and expiration dates. Calculating these points is complex and often requires numerical methods or options analysis software, as it depends on the price of the longer-dated option at the expiration of the shorter-dated option, which itself is a function of the underlying price and implied volatility at that future date.