Diagonal Option Spreads

A diagonal spread is an option spread with different strike prices and expiration dates. A diagonal spread differs from a calendar spread, as far strategy goes, in that purchasing the far term option is less expensive because the strike price is more out-of-the-money. As with a horizontal spread, the near option is generally sold to take advantage of the faster time decay in the last month of an option's term. Like calendar spreads, and unlike the closely related vertical spreads, the maximum profit, maximum loss, and breakeven points can only be estimated, since the time value of the options cannot be known for certainty until spread is closed out.

An advantage of diagonal spreads, as with horizontal spreads with additional expiration dates between the short and long option, is that a spread can be reestablished when the near-term option expires by selling another short option that expires later, but before the expiration of the long option.

Generally, the long side of the spread would expire later than the short side of the spread, especially if the use of margin is to be minimized. If the long option has an earlier maturity date then the short option, then most brokers will require sufficient margin to cover the short option.

Like most spreads, diagonal spreads lowers potential profits, but also lowers potential losses. The maximum profit is generally earned when the underlying asset price is near the strike price of the written option at its expiration.

There are several types of diagonal spreads that are closely related to vertical spreads. A diagonal bull spread increases in value when the price of the underlying increases, while a diagonal bear spread increases in value as the price of the underlying decreases.

There are many possibilities to a spread, so to simplify this discussion, this article will analyze potential profits and losses when the short option expires. The maximum profit from the diagonal bull call spread and the diagonal bear put spread = the difference in strike prices + any remaining time value of the long option minus the debit that must be paid to establish the spread; the debit is also the maximum loss. The maximum profit for the diagonal bear call spread and the diagonal bull put spread = the credit received when establishing the spread + any remaining time value of the long option; the maximum loss = the difference in strike prices + the credit received + the time value of the remaining long option.

Diagonal Debit Spreads

The bull call spread and the bear put spread are both debit spreads because they cost money to establish, since the more expensive, usually closer to the money option, is bought and a more OTM option is sold. Therefore, the profit must be earned by the difference in the strike prices + any remaining time value (TV) of the long option. The long-term option could be held until expiration for a greater profit potential after the near-term option expires.

A diagonal bull call spread is established by selling a call and buying a call with a lower strike price that expires later.

If the price of the underlying is below both strike prices, then the profit or loss will be determined by the difference in the remaining time value of the long call and the debit paid to establish the spread.

If the price of the underlying = the price of the short call, then the long call will be in the money (ITM) by the difference in strike prices + remaining time value. The maximum profit will be equal to the difference in strike prices + the remaining time value of the long option, minus the debit used to establish the spread. Of course, at the expiration of the short call, the long call can simply be held if further increases in the price of the underlying are expected. If the price of the underlying exceeds the strike price of the short call, then the profit will be = to the difference in strike prices + the time value of the long option, which will diminish the more it is in the money. The maximum loss will occur when the price of the underlying is well below the long call's strike price, which will be equal to the debit to establish the spread if the long call is so far out-of-the-money that its time value is 0.

A diagonal bear put spread is established by buying the far option put with a higher strike price and selling the near option put with a lower strike price, which like the bull call spread will require a debit to be paid, with a maximum profit equal to the difference in strike prices + any remaining time value of the long option minus the debit paid.

Diagonal Credit Spreads

A credit is earned when a call spread is established, by selling a more at the money option and buying a more OTM option. However, because the time value adds to the cost of buying the far option, a credit can only be earned when the short option has significant intrinsic value, meaning that it must be in the money. The maximum profit is earned when the near option expires worthless and the far option has significant time value remaining. The maximum loss will be equal to the difference in the strike prices + the credit earned + the time value of the remaining long option.

A diagonal bear call spread is set by selling the near-term call and buying a higher strike call with a later expiration date. This generally results in a credit, which when added to the remaining time value of the long option at the expiration of the short option yields a profit. The maximum loss is incurred when the underlying price = the strike price of the long option, in which case, the short option is in the money by the difference in the strike prices with no offset from the long option. Hence, the maximum loss will be equal to the difference in strike prices minus the remaining time value of the long option, if any.

A diagonal bull put spread is set by selling the near-term ITM put and selling the longer-term OTM put. Like the bear call spread, the maximum profit is earned when the price of the underlying is at the strike price of the short option at expiration, leaving the credit + the time value of the long option as a profit.

Conclusion

Of course, there are many more possibilities than can be listed in this article. For instance, a diagonal back spread can also be established by buying more calls than what is sold. This reduces the risk of buying calls because the cost is offset by the sold short call. If the price of the underlying advances, then the excess long calls will earn a greater profit.

Keep in mind that all spreads, including diagonal spreads, that use American-style options have assignment risk. If a trader is assigned to fulfill the option contract, then there must be sufficient equity or margin in the account to cover the assignment, especially if the trader wants to hold the long option beyond the date of assignment.