The Diagonal Spread Options Strategy
The diagonal spread is a strategy where you enter into long and short positions simultaneously by buying and selling the same types of options (calls or puts), but with different strike prices and different expiration dates. This options trading strategy is a combination of the vertical spread and calendar spread strategies. (In vertical spreads the strike prices are different, and in calendar spreads the expiration dates are different).
This strategy helps manage risk by taking positions at different strike prices and different expiration dates, which provides a certain level of flexibility.
Calculating your Risk
There are two areas of risk with the diagonal spread. If you open the short position at a higher strike price than the long position, a bullish spread, the maximum risk is the debit that is paid up front.
If you open the short position at a lower strike price, a bearish spread, the risk is the difference in strike prices times 100, times the number of contracts, plus the debit that is paid up front.
Because stocks typically rise over the long term, and the risk I mention above, it’s usually better to enter a diagonal as a bullish spread.
Calculating your potential Profit
The profit potential is based on the amount of cash generated from repeatedly selling short positions during the period before the long position expires. If the calendar spread is long, and you open your short positions with near-term expiration dates, you should be able to do this many times over before the long position expires.
Additionally, depending on how In The Money (ITM) the long position is in when it’s closed or exercised, there is the potential for profit here as well.
Diagonal Spread using Calls
The buying and selling of two calls simultaneously each with different strike prices and expiration dates.
A long or bullish call diagonal spread involves buying an ITM long call option with a far out expiration date, while also selling an OTM short call option with a closer expiration date simultaneously. The value of the stock when the short call option expires will determine how much profit you make on that position. And by being able to sell additional short positions, you increase your overall profit potential. The goal is to generate enough profit from the short positions to more than cover the initial debit when the diagonal was opened.
The long will be at risk of time decay and decreasing extrinsic value, depending on how long it is until the expiry date. This is why it performs better as the stock price rises above the long option strike price. The closer the option gets to expiration the more the extrinsic value depreciates, but the higher it is above the strike price the more intrinsic value it has.
If it expires Out the Money (OTM), it will have no intrinsic value and your diagonal spread will only profit from what you make on the short positions. But since you opened the long position ITM, it’s likely the stock price only rose from there and you’re able to profit from it at expiration. So now your total profit is what you made from the short positions, plus what you make at expiration on the long position, minus the initial debit to open the diagonal.
There is also a short or bearish diagonal spread. And similar to a bearish vertical spread, this position remains profitable as long as the stock price remains below the lower short position strike price. If the stock price rises above the short strike price, the P&L line will start to trend negative.
Diagonal Spread using Puts
The selling and buying of two puts simultaneously each with different strike prices and expiration dates.
The short put diagonal spread is selling an ITM put option with a far out expiry date and buying an OTM put with a closer expiration date. The potential profit is limited but does capitalize on the time decay as well as any increase in the underlying asset. One would use this strategy with puts if it is believed that the markets would be moderately neutral or bullish in the short term.
Use Diagonal Spreads to supplement your existing strategies
This multi-legged options strategy requires a certain amount of knowledge and research, but it can also be quite profitable over the long term. You can easily use long bullish diagonal spreads to generate a regular income with minimal risk the same as you can by selling covered calls and cash secured puts.
Let me know what you think of this strategy, or if it’s something you’ve use in the past. Leave a comment below or send me a message! Remember to also check out my YouTube Channel for options trading strategy tips!