Diagonal spread is an options trading strategy that involves buying and selling options with the same underlying asset but different expiration dates and strike prices. It’s a type of option spread that combines elements of both a vertical spread and a horizontal spread. Diagonal spreads can be implemented using either call options or put options, and they can be used for different purposes depending on the trader’s outlook and goals.
Here are the two main types of diagonal spreads:
- Diagonal Call Spread: In a diagonal call spread, an investor simultaneously buys a longer-term call option with a higher strike price and sells a shorter-term call option with a lower strike price. This strategy is typically used when the trader expects the underlying asset to have a moderately bullish outlook. The premium received from selling the shorter-term call helps offset the cost of buying the longer-term call.
- Example: Buy a January 2024 call option with a strike price of Rs.500 and sell a November 2023 call option with a strike price of Rs. 450.
- Diagonal Put Spread: In a diagonal put spread, an investor simultaneously buys a longer-term put option with a lower strike price and sells a shorter-term put option with a higher strike price. This strategy is typically used when the trader anticipates a moderately bearish outlook for the underlying asset. The premium received from selling the shorter-term put helps reduce the cost of buying the longer-term put.
- Example: Buy a January 2024 put option with a strike price of Rs.500 and sell a November 2023 put option with a strike price of Rs.550.
Key points to consider about diagonal spreads:
- Time Decay: Diagonal spreads benefit from time decay. The short-term option you sell will decay faster than the longer-term option you buy. As long as the underlying asset moves in the expected direction (bullish for calls or bearish for puts), the trader can profit from the time decay of the short option.
- Limited Risk and Limited Reward: Like other spread strategies, diagonal spreads limit both potential profit and potential loss. The maximum profit is typically achieved if the underlying asset settles at the strike price of the short option at expiration, while the maximum loss is limited to the net premium paid for the spread.
- Adjustability: Diagonal spreads offer some flexibility for adjustments. Traders can roll the short option to a different expiration date or strike price if market conditions change. This adaptability can be an advantage when managing risk.
- Margin Requirement: Depending on the brokerage and the specific terms of the spread, diagonal spreads may require less initial margin compared to outright buying or selling of options. However, it’s essential to check with your broker for their margin requirements.
In summary, diagonal spreads are a versatile options strategy that can be tailored to different market outlooks. Traders use them to benefit from time decay while managing both risk and reward. It’s crucial to understand the potential outcomes and risks associated with diagonal spreads before implementing them in your options trading strategy.
