What Is A Diagonal Spread, And How Does It Work

November 23, 2022

Options contracts are one of the most complex financial products used by traders and investors to benefit from the price fluctuations of any given asset. Option contracts, like futures contracts, reduce the buyer's risk by allocating a predefined price to an asset. Unlike futures contracts, however, option purchasers are not required to acquire the asset before trading.


What is a Diagonal Spread?

The diagonal spread is an alternative to traditional calendar spread strategies that may be profitable if used appropriately. The amount of flexibility and adaptability provided by a "low intrinsic value" environment approach is unparalleled.


Who Can Benefit from the Diagonal Option Spread?

Trading several options with varying expiry dates and strike prices is part of the diagonal spread strategy. To master the approach, substantial technical expertise and practices are necessary. However, if you're well-versed in the domain of options, this is an unquestionably good method to use.


Break Even Point

Determining the breakeven point while utilizing a diagonal spread approach may be difficult due to the many factors involved. In addition, this method, as previously stated, has two strike prices and two expiry dates. As a result, a complicated pricing model is necessary to assess the value of the back-call months when the front-month call expires.


Diagonal Spread Strategy Tips

  • Don’t Overpay: One crucial piece of advice is to not overpay for your diagonal spread. Pay no more than 75% of the breadth of the spread. Remember that your profit potential is the breadth of the spread, less the debit you've paid.
  • In Bearish Markets, Make Adjustments: Unfortunately, your directional bias sometimes fails. For example, once you make a diagonal call, the price of an asset may fall. In contrast, the price of an asset may rise after you place a diagonal put spread. Don't be alarmed if this occurs; it's the beauty of the diagonal spread. Remember that there is a spacing between your long and short alternatives based on your arrangement.


Implied Volatility Effect

Although you may expect neutral movement in the asset class's price (if it's striking price A) near to the front month's expiry when trading the diagonal spread call, higher implied volatility might work in your favor. If implied volatility exists, you might sell another call option at strike price A and collect a more significant premium. The same is true for the diagonal spread out.


Wrapping Up

The diagonal spread is a hybrid approach that is part vertical and part calendar and has both directional and temporal components. If the underlying asset's price increases in your favor while using this method, you may be paid rapidly while also benefiting in the long run. As a result, the diagonal spread is perhaps one of the most appealing option strategies accessible.

Contrary to common assumption, futures and options trading is not as tricky as it seems. You will utilize these cutting-edge financial products more effectively if you have a thorough grasp of them.


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