Diagonal Spreads

Options Diagonal Spreads Explained

10 min read

Diagonal spreads are an advanced options strategy. You could go either long or short with this strategy. It all depends on how you build the spread. It involves two calls or puts with different strikes and expiration dates. It’s a combination of a calendar and a vertical spread. 

We’ve heard of vertical spreads, but what are diagonal spreads? This strategy requires entering a long and short position with different strikes and expirations. In other words, you’re buying two calls or two puts. Each one has a different strike price and a different expiration. You can be bearish or bullish with diagonal spreads.

Options are such a great way to grow a small account. Diagonal spreads are a more advanced strategy in which to do so. There are many strategies available at your disposal. So, you have options in how and what to trade and when.

One of the best things about options is the ability to profit in any market. Even sideways markets can make you money. As a result, you’re not sitting around waiting for the trend to change or to define itself.

Enter a long and short position with two options of the same type of options, i.e., two calls or two puts, but with different strikes and expiration dates.

If you’re into options or even new to options, you’ll notice options have many strategies to trade. That can make it a bit overwhelming.

Diagonal Spreads Basics

Before we delve into diagonal spreads, let’s cover the basics. An option gives you the right but not the obligation to buy (call) or sell (put) a stock at a predetermined price within a certain time.

One contract controls 100 shares. Hence, there is an appeal for using them to grow small accounts. You can trade large-cap stocks without putting up the capital.

However, options have a lot of moving parts. That makes them more complicated than trading stocks. As a result, they have a reputation for being difficult.

That’s not the case if you take the time to study and practice properly. 

All strategies, including diagonal spreads, are made up of calls and puts. In essence, calls and puts are the foundation of options trading.

Breaking Down Diagonal Spreads

Diagonal spreads are made up of two different types of spreads: calendar and vertical, hence how it got its name.

The calendar spread is horizontal. This is where the different expiration’s come into play. The vertical spreads represent the difference in strike prices.

In essence, you’re using two different spreads to form another strategy. You have both a horizontal and vertical spread. That makes it diagonal.

Each name represents a different position on the board. For example, you can buy a January $30 call option and sell a May $35 call.

You have two different strike prices and two expirations. You’re also buying and selling two options of the same type, i.e., calls.

Diagonal Spreads Example

Diagonal Spreads Example

Types of Diagonal Spreads

There are many ways to do diagonal spreads because of how they’re set up. You can have any strike and expiration you want.

However, be aware that you want to make ones that will be profitable. Your diagonal spreads can be bullish or bearish, long or short.

Most diagonal spreads are considered long. The only requirement for the long diagonal is to buy the option with the longer expiration and sell the option with the shorter expiration. It’s the same for both calls and puts.

If you take the short spread, you’d want to sell the longer expiration and buy the shorter one. The combination of the strike prices makes it long or short, bullish or bearish.

For example, if you’re bullish but short, you’d buy the near expiration with the higher strike price. You’d sell the lower strike price with the far expiration.

Maximum Profit and Using Volatility

Diagonal spreads are strategies in which you want low implied volatility. The more volatility there is, the less it helps you.

That’s not the case when it comes to stocks. The more volatile, the better when trading stocks, especially with a good penny stocks list.

Strategies like diagonal spreads are different. Therefore, you have to be aware that they profit differently.

With credit and debit spreads, you can figure out your maximum profit. Can you do that with diagonal spreads?

The answer is not really. Max profit can’t be calculated because of the different expiration dates. However, you can estimate it depending on the spread you enter by subtracting the width of the strikes minus the net debit paid.

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HIGHLIGHTS

Are Diagonal Spreads Credit or Debit?

When opening diagonal spreads, are you going to get a credit? Or will you pay a debit? Since this strategy employs vertical and calendar spreads, it can differ.

As a result, depending on how you make your spread with expiration and strike prices, you will get a net debit or a net credit.

Many times, diagonal spreads take a net debit out. That means you’re spending money to make money.

With a credit spread, you’re given the money at the start of the trade. However, you could lose the credit by the end of the trade.

Putting Diagonal Spreads Together

Diagonal spreads are going to require practice, just like any other strategy. Options have more moving parts, so you must see how implied volatility and time decay affect your profit and loss.

It would be best to practice because you can do many things with expiration and strike prices. This allows you to figure out what combinations work and which don’t.

That’s so important when it comes to trading. Trading is emotional. It’s hard not to let greed and fear take over.

There’s no denying that there’s a rush when you close out a winning trade. That can end up helping greed take a foothold. You start feeling cocky. That goes away really quickly.

Then losing starts to bring fear in when it’s time to trade. Those emotions don’t help you to become a good trader.

Patterns Matter

There are so many ways to play diagonal spreads. As a result, you need to know how to read a chart along with support and resistance.

This is a strategy that doesn’t want a lot of volatility. Does that mean you don’t want to open this spread on a breakout?

Again, that’s a strategy you’ll want to practice. However, patterns matter no matter what kind of stock market trading you take.

Spotting patterns will help you decide what diagonal spread you want to open. For example, you may want to open a bearish spread on a bull flag fade.

Candlesticks are the name of the game. Not only do they tell a story, they form support and resistance.

We can’t stress to you how important those levels and patterns are. It can be the difference between profit and loss.

Using Technical Analysis

Diagonal spreads are their most profitable with low volatility. As a result, you don’t need or want big moves.

This strategy could work well with stocks trapped between moving averages. They don’t have a lot of room to go on either side while figuring out which direction to go.

You could also pull the trigger or wait depending on where the candlesticks are regarding the moving average lines. That doesn’t mean the stock will do what it should, however.

If we could predict moves 100% of the time, we’d be on something. But we know that stocks break up and down all the time.

Patterns and technical analysis help us predict what’s coming along with trading proper risk management.

Advanced Diagonal Spreads

Diagonal spreads are an advanced options strategy. It’s not highly talked about. But it is one to pay attention to.

Because it’s advanced, you want to start with the basics. Diagonal spreads are a strategy you want to work your way up to.

Start with buying calls and puts. That’s the most basic and popular trading strategy. However, it’s risky. As a result, practice risk management.

Then you can get into spreads. They cap your risk. With spreads, you go into the trade with defined risk and reward. There are a lot of different spread strategies.

Once you learn spreads, then go for the diagonal spread. Take advantage of the building block options provided. It’s a great way to grow a small account.

Final Thoughts

Diagonal spreads are made up of two different spread strategies: calendar spreads and vertical spreads. If you master those two, you can master the diagonal spread. 

If you need more help, take our options trading course.

Frequently Asked Questions

Diagonal spreads are profitable the more that they go in the money (ITM). Intrinsic value increases, which makes them more profitable.

The risks of a diagonal spread are limited. The maximum loss is the width of the spread minus the credit or debit.

  • When in doubt, adjust the spread or close it out
  • Adjust from the short side first
  • Never do a diagonal spread for a debit
  • Chart the stock and look for weaknesses
  • Study the fundamentals
  • Use stocks with great liquidity
  • Be confident in your strategy

A double diagonal option strategy combines a diagonal bull call spread with a diagonal bear put spread. The goal is minimal volatility at first. But there are many ways to profit from this.

A diagonal spread includes a long option that's out of the money. Covered calls replace 100 shares of a security with an in-the-money-long call position.

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