Diagonal spread

Diagonal spread is an advanced options trading strategy that combines elements of vertical spreads and calendar spreads. The trader simultaneously buys and sells options of the same type (both calls or both puts) on the same underlying asset, but with different strike prices and different expiration dates. The name derives from how options prices were historically displayed in newspapers: strike prices ran vertically in rows while expirations ran horizontally in columns, making this strategy appear "diagonal" across the price table^[1].

Structure and mechanics

A diagonal spread involves two positions:

A long option with a more distant expiration date
A short option with a nearer expiration date

The strike prices differ between legs. For bullish strategies, the long call typically has a lower strike than the short call. Bearish diagonal spreads reverse this pattern with puts. The trader pays a net debit to establish most diagonal positions, though the short option premium partially offsets the long option cost^[2].

Time decay works asymmetrically in diagonal spreads. Near-term options lose value faster than distant options. The short leg erodes quickly as expiration approaches, while the long leg retains more value. This differential benefits the spread holder if the underlying price cooperates.

Types of diagonal spreads

Bullish diagonal call spread

The trader buys a longer-dated call at a lower strike and sells a shorter-dated call at a higher strike. Maximum profit occurs when the underlying trades just below the short strike at near-term expiration. The short call expires worthless while the long call maintains substantial value.

Suppose a stock trades at $100. A trader might purchase a three-month $95 call for $10 and sell a one-month $105 call for $3. The net debit equals $7. If the stock sits at $104 when the short call expires, that option becomes worthless. The long call, still having two months remaining, could be worth $12 or more^[3].

Bearish diagonal put spread

This strategy uses puts instead of calls. The trader buys a longer-dated put at a higher strike and sells a shorter-dated put at a lower strike. Profits accrue when prices decline moderately.

Double diagonal spread

Some traders construct double diagonal spreads by combining a call diagonal with a put diagonal. This creates profit potential on both sides of the current price, though at greater complexity and cost.

Risk and reward profile

Diagonal spreads offer defined risk. Maximum loss equals the initial net debit if the underlying moves sharply against the position or if implied volatility collapses. The exact maximum profit depends on where the underlying trades at the short option's expiration and the remaining value of the long option^[4].

Several factors affect profitability:

Price movement: Moderate moves in the expected direction generate the best results
Time decay: Benefits the position as the short option erodes faster
Implied volatility: Higher volatility increases long option value; declining volatility hurts the position
Interest rates and dividends: Minor effects compared to other factors

Advantages

Diagonal spreads offer several benefits to experienced traders:

Income generation: The short option provides premium that reduces cost basis
Defined risk: Maximum loss is known at entry
Flexibility: Positions can be adjusted as market conditions change
Multiple profit sources: Gains can come from directional movement, time decay, or volatility changes^[5]

When the short option approaches expiration, traders can close it and sell another short-dated option (a technique called "rolling"). This generates additional premium and extends the strategy.

Risks and considerations

The strategy involves meaningful complexity:

Assignment risk: Short options can be exercised early, particularly near ex-dividend dates
Volatility exposure: Sharp volatility drops damage long option values disproportionately
Liquidity concerns: Wide bid-ask spreads in less active options increase trading costs
Margin requirements: Brokers may require significant capital or margin

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Practical example

Consider the S&P 500 ETF trading at $480. A moderately bullish trader could:

Buy a 90-day $475 call for $18
Sell a 30-day $490 call for $7

Net debit: $11 (or $1,100 per spread since each option covers 100 shares)

Scenario at 30-day expiration:

If SPY trades at $488, the short call expires worthless. The long call, now with 60 days remaining and deeper in the money, might be worth $18.
If SPY trades at $450, both options lose substantial value, approaching maximum loss.
If SPY surges to $520, the short call gets assigned. The trader must sell shares at $490, though the long call provides offsetting profit^[7].

References

Hull J.C. (2022). Options, Futures, and Other Derivatives, Pearson
Cohen G. (2005). The Bible of Options Strategies, FT Press
Natenberg S. (2015). Option Volatility and Pricing, McGraw-Hill
McMillan L.G. (2012). Options as a Strategic Investment, Prentice Hall

Footnotes

<references> <ref name="fn1">[1] Origin of "diagonal" terminology from newspaper price tables</ref> <ref name="fn2">[2] Basic structure combining vertical and horizontal elements</ref> <ref name="fn3">[3] Example of bullish call diagonal mechanics</ref> <ref name="fn4">[4] Risk profile characteristics</ref> <ref name="fn5">[5] Strategic advantages</ref> <ref name="fn6">[6] Complexity and required knowledge base</ref> <ref name="fn7">[7] Practical outcome scenarios</ref> </references>

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