Diagonal Spreads

How Does Diagonal Spreads Work in Options Trading?

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Diagonal Spreads - Introduction

Almost all options strategies are made up of what are known as spreads. Options Spreads are simply simultaneously buying and shorting different options of the same type on the same underlying stock.

For example, Buying a $30 strike Call Option and simultaneously shorting its $33 strike call option is a spread.

Spreads are extremely important in options trading because spreads enable different risk/reward profiles to be created, giving options trading its legendary versatility. There are many types of spreads namely; Horizontal Spreads, Diagonal Spreads, Ratio Spreads and Vertical Spreads. This tutorial shall explain what Diagonal Spreads are and explore the different types of Diagonal Spreads.

Diagonal Spreads - Content

What are Diagonal Spreads | Types of Diagonal Spreads | Purpose of Diagonal Spreads | Advantages and Disadvantages

What are Diagonal Spreads?

Diagonal Spreads, also known as time spreads or calendar spreads, are options spreads made up of options of the same underlying, same type but different expiration month AND strike prices. In fact, Diagonal Spreads can be considered a combination of Vertical Spreads and Horizontal Spreads. Diagonal Spreads are named Diagonal Spreads because the options that are involved in a Diagonal spread are stacked up diagonally on an options chain.

The example in the picture above is a Diagonal Calendar Call Spread on the AAPL buying its January $90 strike call options and shorting its February $100 strike call options. In fact, Diagonal Spreads are horizontal spreads with different strike prices.

Diagonal spread is simply a way of classifying options strategies using options of the same type but different strikes and month. Knowing or not knowing such classification does not actually affect your options trading in anyway.

Types of Diagonal Spreads

Like Horizontal Spreads, Diagonal Spreads also profit primarily from difference in time decay between the longer term options and the shorter term options, that is why Diagonal spreads are also known as Time Spreads or Calendar Spreads. On top of that, Diagonal Spreads also has the directional advantage of Vertical Spreads, making it more popular than a horizontal spread. There are 2 main types of Diagonal Spreads; Call Spreads and Put Spreads.

Call Diagonal Spreads are Diagonal Spreads utilizing call options. These are also more popularly known as Calendar Call Spreads.

Put Diagonal Spreads are Diagonal spreads utilizing put options. These are also more popularly known as Calendar Put Spreads.

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Purpose of Diagonal Spreads

The purpose for Diagonal Spreads is to profit from both time decay between the longer term options and the shorter term options as well as a directional move, thus combining the characteristics of horizontal spreads and vertical spreads.

Short term options have a higher theta value and hence a higher rate of time decay than longer term options. By making more in time decay from the short term options than what is lost in the long term options, a positive return results. In this case, the longer term options serve to eliminate the margin requirement of shorting the short term options. If margin is not an issue, one could simply short the near term options and take advantage of the full time decay without offsetting by the long term options.

By writing out of the money options instead of the same strike price as in a horizontal spread, the position profits even when the underlying stock moves in a certain direction beyond the strike price of the short term options, just like a vertical spread. This alone makes it a better choice than a pure horizontal spread. In fact, diagonal spreads are also used as leveraged covered calls by buying long term deep in the money LEAPS instead of the stock itself in order to write more out of the money call options against it.

Diagonal spreads are also capable of profiting from increases in implied volatility as the vega value of longer term options is higher than the vega value of nearer term options. However, this is not the primary purpose of putting on a Diagonal spread because a better way to take advantage of volatility is through the use of volatile options strategies or simply by buying the long term options without offsetting by the nearer term options.

Advantages of Diagonal Spreads

Profits from directional or stagnant outlook as well as volatility.

Higher ROI on covered calls than buying the underlying stock itself.

Disadvantages of Diagonal Spreads

Higher commissions due to additional trades.

Lower maximum profit when putting on credit options trading positions.

Changes maximum profit potential of call or put spreads from unlimited to limited.

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