How Diagonal Spread Works

You can create a diagonal spread by buying a put (call) that won't expire anytime soon and selling a put (call) that will expire quickly but has a further strike price. Creating diagonal spreads will help decrease the cost basis. This type of trading strategy is effective in two ways: it assumes a vertical spread and displays a calendar spread effect in terms of positivity. Properly creating a diagonal spread is crucial because an improperly constructed diagonal spread can make you lose a significant amount of money, especially if the trade direction moves the way you want too quickly.

To ensure that you have constructed your diagonal spread properly, you must check the external worth of your In The Money (ITM) option's, which will expire at a further date. After you have verified that, you must ensure that the put (call) you are selling with a nearer expiration date is the same as or more than the amount of the other put (call) with a further expiration date. When your ITM option has an extended expiration date, it becomes easier to construct a diagonal spread. However, you should ensure that the debt paid sum is not over 75% of the strikes' width.

Before closing your diagonal spread, you must ensure that the maximum profit is around 25% and down to 50%. You receive profit if your ITM option with the further expiry date increases in value or if the trade volatility rises. To ensure maximum profit, you should manage your diagonal spread when the stock's current market price increases in a direction against your diagonal spread. When this happens, you must bring down your put (call) with the short expiration to become nearer to the breakeven price.

Example a Diagonal Spread

Hypothetically speaking, a long call bullish diagonal spread indicates that you need to buy the choice consisting of a longer expiration time and a minimal strike price. It also suggests that you should sell the option with a shorter expiration and a higher strike price. For instance, if you have a trade for May, you should purchase a choice, such as a September $100 call option, and sell off a call option of June $150.

Types of Diagonal Spread

Even though a diagonal spread contains the features of a vertical spread and a calendar, it is different because it possesses strike prices. There are mainly two diagonal spreads: the Long Put Diagonal Spread and the Long Call Diagonal Spread.

A Long Put Diagonal Spread is a diagonal spread that involves purchasing a put with a further expiring date and the selling of another put with a closer expiring date to reduce the cost basis. This process is a bearish position that allows you to profit if the trade is volatile.

A long call diagonal spread is a type of diagonal spread that has to do with buying a call with a further expiration date and selling a call with a nearer expiration date to reduce the cost basis. This process results in a bullish position that allows you to profit if the trade becomes volatile.

Importance of Diagonal Spread

A diagonal spread's primary importance is to enable you to profit at the end of the two expiry dates between the short and long-term options, including directional moves, which makes it similar to the vertical spread and the horizontal spread. Short-term trading options have more value and a higher rate of fast expiration than long-term trading options. By making more money from short-term trading options than you lose in long-term trading options, you will experience positive growth in terms of maximum profits.

When this happens, the long-term trading options help reduce the margin needs of reducing the short-term trading options. Suppose the margin is not a source of the problem. In that case, you can reduce the short-term trading options and benefit significantly from the complete expiration disturbing the long-term trading options. Using a diagonal spread instead of the same current market price, you can make profits even when the original stock's value exceeds the short-term trading options' strike price.

This versatility is another reason why a diagonal spread is better than a horizontal spread. Diagonal spreads also allow you to profit where the trade is volatile because the long-term trading options have more value than the short-term trading options.