Diagonal spread

Diagonal spread
See also
Calendar spread Delta neutral Short-term investments Conservative investing Blue chip Slow market Stop-loss order Convenience yield Mezzanine capital

A diagonal spread is an options strategy where a trader will purchase both a call and a put option with different strike prices and the same expiration date. This type of spread allows traders to take advantage of the volatility of the underlying asset while limiting risk. The most common type of diagonal spread is a call spread which involves buying a lower strike price call option and selling a higher strike price call option. A put spread involves buying a higher strike price put option and selling a lower strike price put option.

The potential payoff of a diagonal spread is determined by the difference between the strike prices of the two options. The maximum potential loss is the cost of initiating the spread, which is the difference between the premiums paid for the two options. The maximum potential profit is the difference between the strike prices, less the cost of initiating the spread.

In summary, a diagonal spread is an options strategy where the trader purchases both a call and a put option with different strike prices and the same expiration date. The potential payoff is determined by the difference between the strike prices, and the maximum potential loss is the cost of initiating the spread.

Example of Diagonal spread

For example, a trader could buy a $50 strike price call option for $2 and sell a $60 strike price call option for $1. The cost of initiating the spread would be $1 ($2 minus $1). The maximum potential profit would be $9 ($60 minus $50 minus $1). The maximum potential loss would be $1 (the cost of initiating the spread).

Let's consider an example of a diagonal spread. A trader buys a $50 strike price call option for $2 and sells a $60 strike price call option for $1. The cost of initiating the spread is $1 ($2 minus $1). The maximum potential profit is $9 ($60 minus $50 minus $1). The maximum potential loss is $1 (the cost of initiating the spread).

In this case, the trader will make a profit if the underlying asset moves above $61 and a loss if the underlying asset moves below $49. If the underlying asset moves between $49 and $61, then the trader will break even.

In summary, the example of a diagonal spread consists of buying a $50 strike price call option for $2 and selling a $60 strike price call option for $1. The cost of initiating the spread is $1 and the maximum potential profit is $9. The maximum potential loss is $1 and the break even point is between $49 and $61.

Formula of Diagonal spread

The formula for a diagonal spread is as follows:

Profit/Loss = (Price at Expiration of Long Option - Strike Price of Long Option) - (Price at Expiration of Short Option - Strike Price of Short Option) - Premium Paid

In this formula, the profit or loss of a diagonal spread is determined by the difference between the strike prices of the long and short options, minus the premium paid to initiate the spread. If the long option has a higher strike price than the short option, the spread maximum potential profit is the difference between the strike prices, less the cost of initiating the spread. Conversely, if the long option has a lower strike price than the short option, the maximum potential loss is the cost of initiating the spread.

When to use Diagonal spread

Diagonal spreads can be used when the trader expects the underlying asset to move but the magnitude of the move is uncertain. They can also be used when the trader expects a directional move but is not sure of the timing. Additionally, they can be used to take advantage of time decay, as the short option will decay faster than the long option.

Types of Diagonal spread

• Long Call Diagonal Spread: This is a bullish strategy and involves buying a lower strike price call option and selling a higher strike price call option.
• Short Call Diagonal Spread: This is a bearish strategy and involves selling a higher strike price call option and buying a lower strike price call option.
• Long Put Diagonal Spread: This is a bearish strategy and involves buying a higher strike price put option and selling a lower strike price put option.
• Short Put Diagonal Spread: This is a bullish strategy and involves selling a lower strike price put option and buying a higher strike price put option.

A diagonal spread allows traders to take advantage of the volatility of the underlying asset while limiting risk. Each of these strategies have different risk and reward profiles, and the potential payoff is determined by the difference between the strike prices of the two options. The maximum potential loss is the cost of initiating the spread, which is the difference between the premiums paid for the two options, while the maximum potential profit is the difference between the strike prices, less the cost of initiating the spread.

Steps of Diagonal spread

• Step 1: Choose the underlying asset and the expiration date of the options.
• Step 2: Buy a call option with a lower strike price and sell a call option with a higher strike price.
• Step 3: Buy a put option with a higher strike price and sell a put option with a lower strike price.
• Step 4: Calculate the cost of initiating the spread, which is the difference between the premiums paid for the two options.
• Step 5: Calculate the maximum potential profit, which is the difference between the strike prices, less the cost of initiating the spread.
• Step 6: Calculate the maximum potential loss, which is the cost of initiating the spread.

In order to execute a diagonal spread, the trader must first select the underlying asset and the expiration date of the options. Then, the trader must buy a call option with a lower strike price and sell a call option with a higher strike price as well as buy a put option with a higher strike price and sell a put option with a lower strike price. The cost of initiating the spread is the difference between the premiums paid for the two options. The maximum potential profit is the difference between the strike prices, less the cost of initiating the spread. The maximum potential loss is the cost of initiating the spread.

Advantages of Diagonal spread

• The main advantage of a diagonal spread is that it allows traders to take advantage of the volatility of the underlying asset while limiting risk.
• The cost of entering the spread is limited to the difference between the premiums of the two options, providing a known maximum potential loss.
• The maximum potential profit is the difference between the strike prices, less the cost of initiating the spread. This allows traders to maximize their profits while minimizing their risk.

Limitations of Diagonal spread

• Risk/Reward Ratio: The risk/reward ratio of a diagonal spread is limited, as the maximum potential profit is always less than the maximum potential loss.
• Time Decay: The time decay of a diagonal spread is limited, as the time value of the option contracts will decrease as the expiration date approaches.
• Volatility Risk: The volatility risk of a diagonal spread is limited, as the volatility of the underlying asset will affect the prices of both the call and put options.

Other approaches related to Diagonal spread

• Calendar Spread: A calendar spread is a type of options spread involving the simultaneous purchase and sale of two options of the same underlying asset with different expiration dates. The trader will typically buy a longer-term option and sell a shorter-term option, profiting from the difference in their prices.
• Butterfly Spread: A butterfly spread is an options strategy that involves combining both a bull spread and a bear spread. The strategy involves buying an out-of-the-money call option, selling two at-the-money call options, and buying another out-of-the-money call option, all with the same underlying asset and expiration date. The goal of the strategy is to profit from changes in the underlying asset’s price while limiting risk.

In summary, diagonal spreads are just one type of options spread that can be used by traders. Other related approaches include calendar spreads and butterfly spreads, both of which involve a combination of long and short positions in order to capitalize on changes in the underlying asset’s price.

Suggested literature

• Drnovšek, R. (2013). The spread of the spectrum of a nonnegative matrix with a zero diagonal element. Linear Algebra and its Applications, 439(8), 2381-2387.