A diagonal spread may be a strategy you would like to implement into your trading arsenal. Today we will discuss how a diagonal spread is created. We will also reveal some of the advantages and disadvantages of a diagonal spread.
A diagonal spread is a strategy which occurs when two options are bought or sold. These two options use the same instrument. These two options are of the same type, either two calls or two puts. The two options are at different strike prices, as well as two different cycles of expiration.
When a long diagonal spread is initiated, it can either be a net debit or a net credit to your account. A long diagonal spread consists of an option which you buy with more days to expiration than the option which you sell with less days to expiration. The strikes which are bought or sold to create the diagonal spread will determine if the spread is a debit or credit.
An Example of a Bullish Diagonal Spread
A bullish diagonal spread can be composed by buying an in-the-money call option far out in time. Then, you would sell an additional call option with a dissimilar strike price which is usually a little out-of-the money, along with a closer expiration date.
Below is a risk graph of an example of a Call Diagonal Spread on SPY. This position has a bullish bias.
Figure A. SPY Call Diagonal Spread from Think or Swim
The setup for the bullish diagonal in Figure A is as follows:
- Purchase an in-the-money call, 376 days to expiration. The call purchased is the June 19 2020 280 strike.
- Sell a slightly out-of-the-money call, 45 days to expiration. The short call is the July 19 2019 289 strike.
If you are able to keep an eye on your trade more often, you could explore selling shorter term options which could result in more opportunities to sell multiple cycles using the same long option. Of course, you do have more gamma risk with weekly options. Each cycle that you sell and are able to accrue a profit will lower the cost basis of the long call purchased.
How a Bearish Diagonal Could Be Constructed …
Now let's look at the setup for a bearish diagonal. Figure B below is an example using SPY.
Figure B. SPY Put Diagonal Spread from Think or Swim
The example shown in Figure B above is a setup for a bearish diagonal spread; meaning you think SPY will move down. The setup for this diagonal is as follows:
- Purchase a long term in-the-money put, 376 days to expiration. The put purchased is the June 19 2020 295 strike.
- Sell a slightly out-of-the-money put. The short put is the July 19 2019 284 put.
The diagonal can also be used in a similar manner as a covered call.
A covered call can tie up a lot of capital, because you have to purchase at least one hundred shares of stock to create the basis for a covered call.
A diagonal can help to diminish these capital requirements.
For example, a diagonal spread could be created by buying an in-the-money call option 12 months or more in the future. This call option would immediately have intrinsic value due to it being in the money.
Using the above SPY example in Figure A, SPY is trading at $288. The call purchased in this example is the Jun 19 2020 280 call, which has $8.00 of intrinsic value because it is in-the-money by $8.00. The long option would be a type of stock substitute, as compared to purchasing 100 shares of stock which would be required for a covered call.
Due to buying the option further out in time, which in this case is 12.5 months, there will be some time premium added to the price of the option. Most of this options' premium or cost will be the intrinsic value and the rest will be time value.
Using this same example, the $280 SPY option strike cost was $22.82 and $8.00 of the premium for the option is the intrinsic value. The other $14.82 of the premium, or cost of the option is the time value of the option.
What is the maximum profit potential of a diagonal spread?
The exact maximum profit potential in a diagonal spread can't really be calculated because of the position is using two expiration cycles. However, to give you an idea as you analyze a potential position the profit potential can be estimated with this formula:
- For a bullish call diagonal spread, the width of the call strikes, less the net debit paid, is the approximate maximum profit.
- For a bearish diagonal spread using puts, the same formula applies … the width of the put strikes less the debit paid equals the approximate profit.
What is the breakeven of diagonal spreads?
Once again, the exact breakeven cannot be calculated because of the different expiration cycles of the options in the spread. To give you an idea, however:
- For a bullish call diagonal, the approximate breakeven can be calculated by taking the price paid for the long call, plus the net debit paid.
- For a bearish diagonal spread using puts, the same formula applies … take the price paid for the long put, minus the net debit paid.
Some Key Facts about Diagonal Spreads …
Many traders use diagonal spreads as directional strategies. In this instance, your goal when entering the trade is for the price of the instrument to trade to the short strike option you sold, but not to go beyond the short strike. If the price of the instrument crosses above the short strike of the option you sold, you may want to roll the option out in time and out in price. Or, you could close the short option position before expiration day, if the option has gone in the money. Keep in mind, however, if you choose the keep the position open and the short has gone in-the-money, you run the risk of assignment.
To learn more about assignment in options trading, read the article published on February 3, 2019. The article can be found here: https://aeromir.com/00395/understanding-assignment-in-options-trading
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If you have any particular trade strategies incorporating diagonal spreads and would like to share, feel free to do so below.