The world of options trading is dynamic and ever-changing, requiring traders to think strategically and be prepared for any market condition. The only constant in this strange world is change, and successful traders must be able to adjust their approach accordingly.
Similar to the game of chess, where every move can have a significant impact on the outcome, traders must anticipate market movements and plan their moves carefully.
One popular options trading strategy that combines the principles of chess with the world of trading is the diagonal spread. This unique strategy allows traders to benefit from both time decay and changes in the stock price, which can help to mitigate risk and increase profits.
But how can traders effectively execute a diagonal spread using the principles of chess? They must anticipate their opponent’s next move, in this case, the market, and adjust their approach accordingly.
Every trader’s toolkit needs to contain the diagonal spread. Let’s dive in.
What you’ll learn
The Definition of Diagonal Spread
A diagonal spread is a versatile options trading strategy that involves buying and selling two options with different expiration dates and strike prices. The strategy’s name derives from the diagonal pattern on a graph of the options’ payoff; you can see in the image below that the spread is literally diagonal.
Diagonal spreads are an inherently flexible strategy, allowing investors to profit in unique ways, and also trade in different market conditions. So it doesn’t matter if you are bullish or bearish, you can use diagonal spreads in both scenarios.
In a bullish diagonal spread, the trader typically buys an option with a longer expiration date and a higher strike price than the option they sell. The aim is to profit from the difference in premium between the two options. If the underlying asset’s price increases, the option purchased will become more valuable, while the option sold will decrease in value.
In a bearish diagonal spread, the trader typically buys an option with a shorter expiration date and a lower strike price than the option they sell. The goal is to profit from the difference in premium between the two options. If the underlying asset’s price decreases, the option purchased will become more valuable, while the option sold will decrease in value.
Understanding How a Diagonal Spread Works
Diagonal spreads take advantage of the difference in time decay between two options. Options contracts give the holder the right to buy or sell an underlying asset at a set price (strike price) until a set date (expiration date). However, options lose their value over time. This is known as theta, or theta decay.
In a diagonal spread, the options sold typically have a lower strike price and closer expiration date than the options bought, creating a diagonal shape that you can see on the graph below chart. As opposed to calendar (horizontal) spreads and vertical spreads that have either the strike price or the expiration date held constant.
As the expiration date on the sold option in a diagonal spread approaches, the erosion of its time value accelerates. This can actually benefit the trader if the underlying asset remains stable or moves slightly in the expected direction, as they can still capture profit from the trade.
Different Types of Diagonal Spreads
So far, we’ve briefly mentioned how the diagonal spread is a flexible strategy. Since this is a major advantage in the world of options trading, let’s dive further into what this ‘flexibility’ really means in the eyes of a trader.
The varieties of diagonal spreads can be customized to match different market conditions and a trader’s personal preferences. So just like how some people might prefer chocolate ice cream while others prefer vanilla, traders can choose the type of diagonal spread that works best for them based on their own unique situation.
Diagonal Spread Varieties
|Diagonal Spreads||Diagonal Spreads||Closer to Expiration||Further From Expiration||Strike Price 1||Strike Price 2||Sentiment|
|Calls||Long||Sell Closer||Buy Longer||Buy Lower||Sell Higher||Bullish|
|Short||Buy Closer||Sell Longer||Sell Lower||Buy Higher||Bearish|
|Puts||Long||Sell Closer||Buy Longer||Sell Lower||Buy Higher||Bearish|
|Short||Buy Closer||Sell Longer||Buy Lower||Sell Higher||Bullish|
The first flavor is called the diagonal bull call spread, which is set up by buying a call option with a higher strike price and longer expiration date, and selling a call option with a lower strike price and shorter expiration date. This strategy is great for traders who think the price of the asset will go up, but want to limit their potential losses if it doesn’t.
On the other hand, there’s the diagonal bear put spread. This strategy is good for traders who are moderately bearish on an asset. To set up a diagonal bear put spread, the trader would buy a put option with a lower strike price and longer expiration date, and sell a put option with a higher strike price and shorter expiration date. The goal of this strategy is to profit if the price of the asset goes down.
An Example of Diagonal Spread
Suppose that you are bullish on Apple (AAPL), which is trading at, say, $150 per share, and you believe that it will increase in price over the long-term. But you are also concerned about the potential risks involved and want to minimize your cost and risk.
In this scenario, you could enter into a diagonal spread by purchasing a call option with a longer expiration date and a higher strike price, such as a $160 strike price call option expiring in six months, while simultaneously selling a call option with a shorter expiration date and a lower strike price, such as a $155 strike price call option expiring in one month.
Now, if the stock remains relatively stable or increases slightly, the shorter-term option will lose value more quickly than the longer-term option, allowing you to profit from the spread. But, if the stock experiences a sharp increase in price, both options may increase in value, but the longer-term option will likely increase in value more quickly than the shorter-term option, again allowing you to profit from the spread.
On the other hand, if the stock remains stagnant or decreases in price, the spread may result in a loss. This loss, however, would be limited to the cost of the options, which is the premium paid for the longer-term option minus the premium received for the shorter-term option.
Trading With Diagonal Spreads
Trading with diagonal spreads can be like navigating the river of the market in a kayak, making it both exciting and challenging. So proper preparation is needed before you start paddling.
One of the most critical aspects of trading diagonal spreads is carefully selecting the options to be bought and sold. This requires a thorough analysis and understanding of the underlying asset’s movements, and consideration of factors like strike price, expiration date, and volatility.
To make informed trading decisions, traders can use various tools and resources, such as charts and technical indicators, to help identify market trends. By being attentive to market movements and using these tools, traders can make more informed decisions about which options to buy and sell.
Traders also need a well-defined plan for entering and exiting the trade. Using stop loss orders can be employed to have a failsafe plan to sell a contract at a price you set, just in case you’re busy doing other things and aren’t around to sell the position.
Profit & Loss Potential of Diagonal Spread
A diagonal spread strategy comes with relatively low risk, but it also has a limited profit potential.
As we’ve reviewed so far, when the underlying asset remains stable or moves slightly as expected, the trader can make a profit. This happens because the shorter-term option loses value faster than the longer-term option due to its shorter time until expiration, causing its time decay to be greater.
And as far as losses go, you’re good. Because if the underlying asset moves significantly in the opposite direction, the trader may experience losses, but these potential losses are limited to the net debit paid for the trade.
Comparing the Differences
Diagonal spreads are pretty flexible when it comes to strike prices and expiration dates. This means that traders can customize their positions more accurately and potentially benefit from specific market conditions. Plus, they’re generally cheaper and less risky than other options strategies, which makes them a popular choice for traders who prefer a more conservative approach.
However, other strategies like vertical spreads and calendar spreads may offer greater profit potential depending on market conditions. A vertical spread, for instance, can yield a larger potential profit if the underlying asset moves significantly in the expected direction. Meanwhile, a calendar spread can be an effective strategy for traders who want to profit from time decay.
It’s crucial for traders to weigh the advantages and disadvantages of each strategy before settling on one that’s best suited for their trading goals and risk tolerance. We’ll get into the specific advantages and disadvantages here shortly.
Another thing to note is that some traders opt to use a mix of different strategies to diversify their portfolios and increase their chances of success.
Vertical Spread vs. Diagonal Spread
Vertical spreads and diagonal spreads are both well-liked option trading strategies, but they do have some key differences. Vertical spreads involve buying and selling options that expire at the same time but have different strike prices. Depending on the outlook, traders either buy an option with a lower strike price and sell one with a higher strike price or vice versa.
On the other hand, diagonal spreads let you buy and sell options with varying expiration dates and strike prices. This means you have more flexibility to fine-tune your positions, and it could lead to lower costs and risks compared to vertical spreads.
|Vertical Spreads||Diagonal Spreads|
|Involves buying and selling options with the same expiration date but different strike prices||Involves buying and selling options with different expiration dates and different strike prices|
|Has a fixed maximum profit and loss||Has a potentially unlimited maximum profit and loss|
|Often used for directional trades||Often used for income generation or hedging strategies|
|Has a higher probability of success, but lower potential profitability||Has a lower probability of success, but higher potential profitability|
One key point to note is that diagonal spreads are generally used for longer-term strategies, whereas vertical spreads are more commonly used for short-term ones. That’s because vertical spreads depend on price movements happening within a shorter time frame, while diagonal spreads aim to profit from longer-term price movements.
When it comes to risk and reward, vertical spreads can yield a higher potential profit if the underlying asset moves significantly in the expected direction. Diagonal spreads, on the other hand, take a more conservative approach with limited profit potential, but also lower risk.
Calendar Spread vs. Diagonal Spread
Calendar spreads and diagonal spreads are both types of spread trades that involve buying and selling options with different expiration dates. However, they differ in terms of the strike prices used. Calendar spreads involve buying and selling options with the same strike price, while diagonal spreads involve buying and selling options with different strike prices.
Calendar spreads are often used for neutral to slightly bullish positions, with the expectation that the underlying asset will remain relatively stable or experience only slight upward movement. In this strategy, the trader buys a longer-term option and sells a shorter-term option with the same strike price. The goal is to profit from the time decay of the shorter-term option, while the longer-term option remains relatively stable in value.
|Calendar Spreads||Diagonal Spreads|
|Involves buying and selling options with the same strike price but different expiration dates||Involves buying and selling options with different expiration dates and different strike prices|
|Typically has a lower cost to enter||Typically has a higher cost to enter|
|Often used for generating income through time decay||Can be used for generating income or directional trades|
|Has limited risk and reward potential||Has potentially unlimited risk and reward potential|
|Profits from time decay and volatility decrease||Profits from volatility changes and directional moves|
Diagonal spreads, on the other hand, can be used for both bullish and bearish positions, and offer greater flexibility in terms of strike prices and expiration dates. This can allow traders to fine-tune their positions more precisely and potentially benefit from larger price movements in the underlying asset.
However, diagonal spreads also come with greater risk compared to calendar spreads, as the trader must monitor both the movement of the underlying asset and the time decay of the options involved. Calendar spreads, by contrast, offer a more conservative approach with a limited profit potential but also lower risk.
Advantages and Disadvantages of Diagonal Spread
Diagonal spreads are a go-to option trading strategy because they offer flexibility and lower entry costs. Compared to some other strategies, diagonal spreads have lower risks because the potential loss is limited to the net debit paid for the trade.
Despite its advantages, diagonal spreads have their downsides too. The profit potential is limited compared to other strategies, and if the underlying asset moves significantly in the opposite direction, traders may face losses.
Here’re the distilled advantages and disadvantages to be aware of:
- Greater flexibility in terms of strike prices and expiration dates compared to some other strategies
- Potentially lower costs and risks compared to some other strategies
- Can be used for both bullish and bearish positions, making them a versatile tool for traders
- Potentially earn a profit if the underlying asset remains stable or moves slightly in the expected direction
- Limited profit potential compared to some other strategies
- Potential for losses if the underlying asset moves significantly in the opposite direction
- Requires a good understanding of options trading and a solid strategy for managing risk
Wrapping things up, diagonal spreads can be a powerful tool for traders looking to maximize profits while minimizing risks in the world of stock options. Their flexibility and ability to fine-tune positions to match market conditions make them attractive options trading signals for both bullish and bearish traders.
However, it’s important to keep in mind that diagonal spreads come with their own set of advantages and disadvantages. While potentially cheaper and less risky than other strategies, they also have a limited profit potential and can result in losses if the underlying asset moves significantly in the opposite direction.
That being said, with a solid understanding of options trading and a clear plan for managing risk and exiting trades, diagonal spreads can be a valuable addition to any trader’s toolkit. Give them a shot, see if they can find a place in your investment strategy!
Learning More About the Diagonal Spread: FAQs
What Exactly is a Diagonal Spread?
A diagonal spread is a fairly advanced technique in options trading that involves buying and selling options contracts with different strike prices and expiration dates. The purpose of this strategy is to create a trade that is cost-efficient, with limited risk and potentially unlimited profit potential. By using options with different expiration dates and strike prices, traders can create a position that is flexible and can be adjusted as market conditions change.
What Risks Are Involved With Diagonal Spreads?
The primary risk associated with a diagonal spread is that the underlying asset may not move in the expected direction, resulting in potential losses. Additionally, if the options expire before the price of the underlying asset moves in the desired direction, the trader may not realize any profit from the trade. Traders can manage this risk by selecting appropriate strike prices and expiration dates, and by implementing risk management strategies such as stop-loss orders.
Is a Diagonal Put Spread Bullish or Bearish?
A diagonal put spread is a bearish strategy because it involves buying a put option with a lower strike price and longer expiration date and selling a put option with a higher strike price and shorter expiration date. This type of spread is designed to profit from a decrease in the price of the underlying asset.
How Profitable Are Diagonal Spreads?
A diagonal spread can be profitable if the underlying asset moves in the expected direction and the trader manages the trade effectively. The profitability of the trade will depend on the specific configuration of the spread, the price movement of the underlying asset, and the timing of the trade.
Are Diagonal Spreads a Better Option Than Credit Spreads?
There is no clear answer to whether diagonal spreads are better than credit spreads, as both strategies have their own unique advantages and disadvantages depending on the trader’s objectives and market conditions. Diagonal spreads can offer greater flexibility in strike price selection and expiration dates, while credit spreads may offer more consistent profitability. Traders should carefully evaluate both strategies and determine which is best suited to their individual trading style and objectives.