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Diagonal Spreads

An option spread trading position where the strike price and expiration months are different, is known as a diagonal spread. These option strategies can be bearish or bullish. Diagonal trading will be profitable or at a loss based on the performance of the underlying stock, while keeping the months and strike prices of the spread in mind.

All spreads are based on buying and selling calls or buying and selling puts.

Diagonal Option Example

Buy 1 DFG Sep 80 Call at $400
Short 1 DFG Oct 90 Call at $200

This is a debit diagonal spread position. It is a debit because the trader loses $200 on the premiums. If the options expire, that will be the investors maximum loss.

The gain comes from the strike prices within the spread. The most this person can make is the 10 point difference in the diagonal strategy, minus the $200 lost on the premium. By chosing a longer month on the sell, the investor was looking to collect a higher premium onm that option contract. Options that have longer expiration months will carry a higher premium than a contract with the same strike price for a shorter month..

The risk to the trader, beyond the initial premium loss is the short call will be exposed for 1 month if it is not exercised with the long call. Diagonal spreads always have months that are different. Sometimes it is on the buy or the sell, on calls or on put options.

Buy 1 KLJ Nov 40 Put at $600
Short 1 KLJ Dec 45 Put at $950

Using put options, a diagonal spread can be created by purchasing and selling put options with different strike prices and months. This is a credit spread. The investor made $350 on the premiums, so the best case outcome here is for the options to expire worthless. This would allow the diagonal spread investor to keep the premium gain with no exposure on the contracts themselves.

This trading investor does not want the options exercised because it will create a negative spread within the strike prices. The person has the right to sell the stock at 40 on the long put, but must buy the stock at 45 on the short put. That would result in a 5 point loss on the stock, minus the $350 gain on the premium for a total loss of $150. Not a big loss, but it's still a loss.

Diagonal option spreads can be less risky than straight selling of uncovered options. With these strategies, the buy covers the sell. On some diagonals, the expiration month for the short can be longer. In those cases, loss exposure is greater.

Intrinsic Value Option Formula

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