Diagonal Option Spread

Table of Contents
Chapter 1: What are Option Spreads
Chapter 2: Vertical Option Spreads
Chapter 3: Calendar Option Spreads
Chapter 4: Diagonal Option Spread
Chapter 5: Trading Options with Spreads

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Chapter 4: Diagonal Spread
Reverse Diagonal Spreads

Chapter 4: Diagonal Spread

Diagonal spreads combine the strategies used in vertical and horizontal spreads, i.e. they are constructed using two options with different strike prices and different expiries. One of the easiest ways to do it would be to keep everything the same in a horizontal spread and just change the strike price of one of the legs.

Although this changes the risk-return profile of your position to some extent, you are still trying to benefit from a difference in Thetas of the two legs, as you do in a simple horizontal spread.

Go back to the example where we bought an OTM $105 call for stock A and sold an FOTM $110 call both with the same expiry, but this time sell the OTM call with October expiry ($4 premium) and buy the FOTM one with a November expiry ($2 premium). You will have a credit of $200 in your account after the transaction is completed. You will lose when the underlying goes up and your maximum loss will be at an underlying price of $110.

But the key difference here from the vertical spread is that we now have a position Theta positive. The November call will have a lower Theta and will have a negative impact on the position, while the October call will have a higher Theta and have a positive impact. This means that the spread will gain further in value as the October expiry comes closer.

Another key difference here is that unlike in horizontal spreads, here the spread can start off with a neutral or slightly negative position Vega. This is because we are using a combination of expiries that are closer together, as again horizontal spreads, where we preferred expiries that were much farther from each other.

As expiry comes near, a diagonal spread turns position Vega positive. This gives you an opportunity to increase your profits when you are using a put base spread and the underlying goes into a steep decline, as such declines are accompanied with an increase in implied volatility.

Reverse Diagonal Spreads

Reverse diagonal spreads can be constructed by simply reversing the order of transactions of a regular diagonal spread. If you were building the spread using calls, you would now buy the OTM call and sell the FOTM one.

This would mean that you would now have a negative Theta spread, and you will lose money with the passage of time. You would also be Vega negative now as the expiry comes closes. You should open such a spread when you are expecting a significant drop in implied volatility.

Next Chapter: Trading Options with Spreads