Diagonal Spread: The Definitive Guide [2019]

Diagonal Spread: The Definitive Guide [2019]

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Diagonal spread

This is the best guide to the diagonal spread option strategy on the internet.

No matter whether you are a complete options trading beginner or someone who has experience trading the markets, but needs a quick refresher, this guide is for you.

Before publishing this blog post, most of the information on the diagonal spread option strategy, there was very little information on the internet that was accurate on what this options trading strategy is and how it works.

But, good news:

I was able to create the most comprehensive guide on the diagonal spread so you can have all the information you need in one place.

Best of all?

It’s information coming straight from an active options trader with years of experience in the markets.

So, follow along so you can learn how to trade the diagonal spread for consistent trading results.

Let’s get started!

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1

How Do Diagonal Spreads Work?

In this chapter, I’ll show you the exact steps you need to trade the diagonal spread in your options trading account.


First, I’ll show you the basic setup.


Then, I’ll show you how to calculate key metrics like your maximum profit potential and maximum loss.

 

Let’s get started.

The Diagonal Spread Option Strategy Setup

The diagonal spread option strategy is a defined risk options trading strategy that benefits from a directional move in the price of the underlying.

What’s unique about the diagonal spread is that you can either use call options or put options to construct this trade.

If you trade a diagonal spread using call options, you want the underlying stock price to go higher to make money.

But, if you trade a diagonal spread using put options, you want the exact opposite to happen if you want to be successful.

Here are the exact components of the diagonal spread:

  • Sell 1 front month out of the money call or put
  • Buy 1 back month slightly in the money call or put

This is what the diagonal spread strategy looks like on a profit and loss diagram:

Call Diagonal Spread Option Profit and Loss Diagram

Call Diagonal Spread

Put Diagonal Spread Profit And Loss Diagram

Put Diagonal Spread

Here are a few things to remember when trading this options strategy:

First, you want to make sure that your front month option has about 30-45 days until expiration. This will give you enough time for the trade to work in your favor.

The back month option should be the next consecutive monthly options expiration cycle.

So, this would give you something like January front month, February back month, for example.

The diagonal spread is a debit strategy, so you are a net buyer of option premium.

This is because the back month option has more time value or extrinsic value than the front month option since there is more time until expiration.

So, you end up paying a higher price for the back month option than the option premium collected from selling the front month option.

But, don’t worry too much about buying premium using the diagonal spread because it’s still a positive theta strategy.

I’ll get more into the effect of time on this options strategy more later on in this post.

The Combination Of A Vertical Spread And A Horizontal Spread

The diagonal spread option strategy is really the combination of a vertical spread and a horizontal spread.

So, what does this all mean?

A vertical spread is a type of option strategy that uses two different strike prices, but all within the same expiration cycle. This is what a credit or debit spread is.

A horizontal spread is a type of option strategy that uses two different expiration cycles, but the same strike price. This is exactly what a calendar spread is.

So, the result of combining the vertical and a horizontal spread is a diagonal spread, where the strategy spans two different strike prices and two different expiration cycles.

How To Calculate The Maximum Profit Of A Diagonal Spread

Just like a calendar spread, the diagonal spread spans two different expiration cycles.

Because there are multiple expiration cycles involved, you can’t calculate the maximum profit potential of the diagonal spread.

This is because is impossible to know what the back month option is worth when the front month option is at expiration.

If implied volatility ends up going higher, you will have a higher profit than if implied volatility decreased.

So, in short. It all depends.

But there is one back of the hand method to approximating your maximum profit potential.

Pro Tip For Calculating Maximum Profit

All you have to do is take the width of the strikes and subtract the net debit paid to initiate the trade.

How To Calculate The Maximum Loss On A Diagonal Spread

The diagonal spread is a defined risk options strategy, so you know ahead of time the most you can possibly lose if things go against you.

Similar to other debit option strategies, the maximum loss is the net debit paid to initiate the trade.

Because it’s a defined risk option strategy, you cannot lose more than what you paid.

This makes the diagonal spread a great defined risk stock replacement strategy (poor man’s covered call).

I’ll get more into the details of how this works later in this post.

How To Calculate The Break Even Point Of A Diagonal Spread

Like trying to calculate maximum profit on a diagonal spread, it’s also pretty difficult to calculate the break even point of a diagonal spread.

This is because the strategy spans multiple expiration cycles.

However, there is a quick back of the hand way to approximate your break even point.

Pro Tip For Calculating A Diagonal Spread Break Even Point

  • For call diagonal spreads, simply take the long call strike and add the net debit paid.
  • And for put diagonal spreads, take the long put strike and subtract the net debit paid.

So, as long as the stock price stays above your break even point for call diagonals and below your break even point for put diagonals, you’ll be profitable.

But, if the stock price were to move against you past the the break even point, you would see losses on the trade.

How Does Time Affect The Diagonal Spread?

The diagonal spread is a theta positive strategy.

So, even though you are a net buyer of option premium, you actually make money as time goes by.

Here’s how that works:

The back month option that you bought has negative theta, so you are losing money as time passes on that leg of the spread.

But, the front month option that you sold has a higher positive theta.

This is because options with less time to expiration has higher theta than options with more time to expiration.

The net result is a positive theta decay.

How Does Volatility Affect The Diagonal Spread?

When you initiate the diagonal spread, you want implied volatility to be low so you can buy the spread for the cheapest price possible.

But, through the life of the trade, you actually want implied volatility to increase.

Remember:

You bought an option in the back month that has positive vega.

And options with more days until expiration have a higher vega than options with fewer days until expiration.

So, the net result is that you want implied volatility to increase.

This will make the value of the back month option that you bought increase in value, so you can sell it at a profit.

How Does The Stock Price Affect The Diagonal Spread?

Diagonal spreads by nature are directional options strategies.

For call diagonal spreads, you want the stock price to increase, while for put diagonal spreads, you want the stock price to decrease.

So, you would only use this options trading strategy if you have a directional assumption on the underlying price.

But if you setup the diagonal spread correctly, you can also make a profit if the stock price doesn’t move at all.

2

A Real Life Diagonal Spread Example

In this chapter, I want to show you a real life example of the diagonal spread option strategy.


This example will help solidify all the concepts we’ve discussed so far in this post.


If you’re ready, let’s dive in.

Diagonal Spread Example

In this chapter, let’s go through a real life diagonal spread I constructed in my tastyworks trading platform for a bullish setup.

Here’s what it looks like:

diagonal spread table mode

Here are the exact strikes and expiration cycles I used for this trade:

  • Short 1 Jan 39 strike call option
  • Buy 1 Feb 36 strike call option

As of this writing, this spread is trading for $2.12, which is $212 in dollar terms.

So, if things end up not going as planned, I could potentially lose $212 at most.

As we can see from the trading platform calculated metrics, some things are “zero” like probability of profit and maximum profit.

diagonal spread trade metrics

This is because this trade involves multiple expiration cycles like discussed earlier.

As for the break even point on this particular diagonal spread, we can approximate it to be the strike price of the long call option plus the debit paid.

So, for this trade that would be $36 plus $2.12, which is $38.12.

If at expiration the stock price is above $38.12, this trade will make a profit; below $38.12, this trade will lose money.

Diagonal spread curve mode

Here’s some other important metrics to note for this trade:

  • Delta is 30.40. Since this is a positive number, we want the stock price to go higher to make a profit. You can also deduce that you are long about 30 shares of the underlying. So, you can use this as a measure of your approximate risk.
  • Theta is 0.24. Theta here is a small positive number meaning this trade makes money as time goes by even though this is a net buying premium options strategy. However, since theta is slightly positive, this is not where the bulk of profits lay in this strategy. You really want the stock price to move in your favor.

Lastly, vega is positive with this strategy (though not explicitly calculate on the trading platform). So the best case scenario with this trade is that the stock price rises above $38.12 and implied volatility increases.

This situation would maximize the value of the long call option that you bought relative to the short call option that you sold, allowing you to sell the spread for a higher price at a profit.

3

Calendar Spreads vs. Diagonal Spreads: Which Is Better?

In this chapter, I want to compare two very similar strategies: the calendar spread and the diagonal spread.

 

I’ll show you the exact pros and cons of each strategy.

 

I’ll even tell you some insider tips on when the best situation is to use each strategy.


Let’s dive in.

Calendar Spreads vs. Diagonal Spreads

The calendar spread and the diagonal spread are two very similar options trading strategies, but there lies in one fundamental difference.

The calendar spread is a neutral strategy, while the diagonal spread is a directional strategy.

So, both options trading strategies are constructed by selling a front month option and a buying a back month option to take advantage of the theta differential between expiration cycles.

This also makes both strategies net debit strategies best utilized in low implied volatility environments with the hopes of implied volatility increasing in the future.

(Low implied volatility means cheaper options prices. And when you’re a net buyer of options, you want to buy at a cheap price)

Differences Between The Calendar Spread and the Diagonal Spread

So, what’s the main difference?

The main difference between the calendar spread and the diagonal spread is the strike selection.

If you aren’t familiar with the calendar spread, you can check out a guide I wrote on this exact strategy here. 

Calendar spreads use the same strikes between the front and back months. Since, these are typically the at-the-money strike, this makes a neutral strategy where you want non-movement in the price of the underlying.

On the other hand, the diagonal spread is inherently a directional strategy where you want the stock price to move in a favorable direction.

With the call diagonal spread, you want the stock price to go higher, while with the put diagonal spread, you want the stock price to go lower.

Without favorable movement in the underlying stock price, it will be difficult to see a profit on this particular options trading strategy.

So, here the key when to use the calendar spread or the diagonal spread option strategy:

Calendar Spread vs. Diagonal Spread

  • If you believe that the stock price won’t move, use the calendar spread.
  • If you believe that the stock price will move sufficiently in either direction, use the diagonal spread.

How To Make The Calendar Spread Directional

Here’s one caveat:

You can actually skew the calendar spread to one direction or the other by positioning the calendar spread strike out of the money in either direction (upside or downside).

By skewing the calendar spread, you create a direction strategy where you want the underlying price to move in your favor.

The one downside to this is that if the underlying price moves too far in your direction, you could actually lose money. This is because there is a much smaller profit window for the calendar spread.

While with the diagonal spread, if the underlying price move dramatically in your direction, you will maintain a profit.  

4

How To Trade The Poor Man's Covered Call (Diagonal Spread Use Case)

There’s one popular variant of the diagonal spread option strategy.


That’s the poor man’s covered call.


This is a popular variant on the strategy because of the leverage it provides when compared to the standard covered call strategy.

 

(You have less risk for the same profit potential)


So, if you’re ready, let’s jump right in.

What’s The Poor Man’s Covered Call?

In simple terms, the poor man’s covered call is one variant on the standard diagonal spread.

Let me explain.

The poor man’s covered call is a version of the diagonal spread that you want to use when you want to replicate the covered call strategy.

Stock Replacement Strategy

A stock replacement strategy is a type of options trading strategy that uses the power of options contracts to achieve a similar payoff profile as stock, but with less risk and a higher return on investment.

So, with the covered call strategy, you have to buy 100 shares of stock and sell 1 out of the money call option.

This means you need the capital required to purchase 100 shares of stock, which could potentially be a large amount.

Then you sell a call option against the 100 shares to collect some option premium to offset the cost of purchasing the 100 shares.

The downside to the standard covered call strategy is that it is capital intensive and you theoretically have unlimited risk.

(The stock price can go to zero)

That’s where the poor man’s covered call version of the diagonal spread comes into play.

Instead of purchasing 100 shares of stock outright, you can purchase an in the money call option to replace the shares.

So, just like the standard diagonal spread, you are selling a front month out of the money option and buying a back month in the money option.

The difference here is that you can separate the two expiration cycles by more than one month so you can have multiple rolls built into the trade.

What this effectively does is dramatically reduce the amount of capital required, increasing your return on investing, and defining your risk.

How Does The Poor Man’s Covered Call Replicate Stock?

So, going back to the basics, one options contract represents 100 shares of stock.

With a call option, that means you have the right but not the obligation to buy 100 shares of stock.

But, an options contract is a much cheaper and more capital efficient way of controlling 100 shares of stock.

Further, you can even look at the delta of the options contract that you are buying.

If you purchase a 60 delta option, then you are effectively controlling 60 shares of stock. If you purchase a 100 delta option, then you are effectively controlling 100 shares of stock.

Again, using options requires far less capital and you have defined risk.

Thus, it can be a good idea to use options to replicate stock.

Who Should Use The Poor Man’s Covered Call?

The poor man’s covered call version of the diagonal spread is perfect for those with smaller options trading accounts.

With smaller trading accounts, it can often be difficult to buy 100 shares of stock. That’s because with an averaged price $50 stock, that's $5,000 you have to commit to one trade.

On top of that, you have the potential to lose the entire $5,000.

So instead, you can use the poor man’s covered call strategy where you may only need to risk $400 to achieve a similar risk and reward potential.

This gives you less risk, less capital required, and a higher return on capital.

Now It's Your Turn

Well, that’s it for my guide on the diagonal spread option strategy.

 

I hope you enjoyed it!

 

So, what concept from today’s guide are you going to try to implement into your own trading strategy?


Or maybe you have a question on one of the topics discussed on the diagonal spread?


Either way, let me know by leaving a quick comment below, right now.

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