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Diagonal Spreads

Diagonal Spread Option Graph

In Options Terminology, a "vertical" position uses two or more options with the same expiration month, but different strike prices. A bull call is a vertical strategy.

A "horizontal" position uses two or more options with the same strike price, but different expiration months. A calendar is a horizontal strategy.

To "diagonalize" a position means to use a position that is normally a vertical, but use a different expiration month for one of the strikes. Or to use a position that is normally a horizontal, but use a different strike price on one of the expirations. There is one diagonal option strategy used often enough to have its own name - the "Double Diagonal". If you examine the parts of a double diagonal you can see that it consists of a diagonal bull put and a diagonal bear call.

The advantages of diagonalizing depend on the strategy and your outlook for the stock. They may include:

  1. An increased "sweet spot" at your target price.
  2. A better breakeven price.
  3. Less risk if the stock moves beyond the sweet spot.
  4. The ability to set up for both a short term gain and a longer term gain.
  5. The chance to take a gain on a short option in the near month, and continue to hold the far month, or sell another short option against the far month.
  6. The chance to own a long option "for free".

For example, let's say you see a "swing trading" opportunity in a stock. It now seems to be ready to bounce off a support level of 45, and you expect the 50 level to be resistance by the next expiration. You also think the stock could move higher than 50 over time. One strategy you could use for this situation is a bear call with the short strike at 50 and long strike at 55. As long as the stock is at 50 or below by expiration, the strategy will have a small gain.

However, by diagonalizing the spread, you gain all the advantages noted above. To diagonalize the 50-55 bear call, you would move the long 55 strike out to the next expiration month. If the stock gets close to the 50 target by the first expiration, but stays below, your gain is increased. If the stock stays below 50, the gain on the short call covers the entire cost of the long call, thereby letting you own the long call with a month left "for free". If the stock then moves higher by the later expiration, you could have significant gains on the long call as well.

If you move the long expiration out two months beyond the short call, you do worse to the downside, but better to the upside. You also lose the ability to own the long call "for free", since the position is entered for a debit (the long 55 call with three months to expiration has a higher premium than the short 50 call with one month to expiration).

Diagonalizing a strategy will always have some sort of a tradeoff. In the case of this diagonalized bear call, if the stock does not get near 50, it does worse than a normal bear call.

The graphs at the top and bottom of this page are not normal option graphs. Instead, we are comparing the expiration graphs of a bear call entered with 30 days to expiration (the black line), a diagonalized version with an additional month to expiration on the long strike (brown line), and a diagonalized version with two additional months to expiration on the long strike (purple line). By diagonalizing a bear call in this way, we have made it sort of a cross between a bear call and a calendar call. And as a matter of fact, if we had started with a normal 50 strike calendar call and diagonalized it by changing the far month strike to 55 from 50, it would be the exact same position.

 

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