Diagonal Spread Strategy
“Limited risk/reward trade very similar to the Calendar spread”
Overview/General Remarks
The Diagonal spread is essentially a calendar spread with only one difference, the long strike is different than the front month short strike. The most notable advantage, in my eyes, to the diagonal spread is it allows for easier profit tents when trading double diagonals (discussed later). The diagonal can be used with puts or calls or both in the case of double diagonals.
Overall, the diagonal spread is just the calendar spread but when purchased you’ll typically receive a credit and when sold you’ll pay a debit. For a review of the calendar spread strategy click here.
Expectations
Employ this strategy at any expected price range as the ideal scenario is to have the option expire underneath the profit tent (shown below). If price is expected to remain flat deploy an ATM diagonal, if bullish, an OTM call diagonal, and if bearish, an OTM put diagonal.
Setup/Construction
This strategy is basically a vertical spread bought or sold across different months. Sell any strike put or call and simultaneously buy a put or call at a different strike in a different month. Either both calls or both puts not a combination of one and the other.
Warning – The Diagonal spread has a front month short option. Be aware of the obligations. To review option basics click here.
Example Diagonal Spread
Example trade on SPY etf. Click to Enlarge.
Max Reward/Loss
Max reward = Cannot truly be calculated as both options are in different expiration cycles. This example at the peak of the profit tent shown above suggests a profit of $135.00.
Max loss = strike width minus the credit received or $1 – .47 = $.53 or $53
The blue line represents the max profit at the peak and the max loss is noted on the right horizontal section. Note also that should the spread expire below the short strike the initial credit is yours to keep. Meaning, the only way to lose with this strategy when initialized with a credit is to have price run past the short strike and expire beyond it.
Price Assumptions
Would like to have price fall under the profit tent preferably keeping the short strike option OTM.
Key Benefits of the Diagonal Spread
– Hedged position
– Limited risk
– Low margin requirement
– Positive theta (depending on initial setup)
– Easy to adjust
Volatility
IV = 14.36%
IV Rank = 18.39%
Ideal in low implied volatility environments. At this time I would likely avoid the diagonal or calendar spreads.
Probability ITM/OTM
It would be optimal to have the short strike expire OTM to keep the entire initial credit (In this case guaranteeing a profitable trade) and leaving a free long option to either sell, roll, close, let expire worthless, or initiate a new diagonal with the sell of another short option. (If its not intended to keep a new position open, sell the remaining long option for obvious reasons) 😉
This example suggests a 62% probability of expiring profitably.
Final Thoughts
Much like calendar spreads I really enjoy the diagonal spread. With a positive theta setup and easy adjustability the diagonal spread is a prime candidate for newer option traders to consider.
A few tips – look to employ diagonal spreads in low volatility markets, ensure the front month volatility is higher than the back month, if price moves past the short strike look to roll to another OTM short strike or close the short strike all together.
Have something to get off your chest about diagonal spreads? Don’t go without leaving a comment below.
Disclaimer
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You said, “I would not be looking to do a diagonal now”; might be nice to know when the “now” is. Was this written in 2008? 2011? First part of 2018? Would be good to add a simple date to your writings.
Thank you for the suggestion, I certainly will going forward. That statement was in reference to the written volatility level just before. I intended to highlight that the volatility level wasn’t what I prefer when looking to setup a diagonal spread. Feel free to message anytime.
God bless,
Jeff