Diagonal Spread Definition

A diagonal spread is an options trading strategy that combines the vertical nature of different strike selections in a vertical spread, with the horizontal nature of different contract durations in a calendar spread. 

Diagonal spreads are typically set up like vertical debit spreads, where the long option has a longer duration than the short option. This strategy is typically used to take directional assumptions on products in a defined risk way, while still reducing cost basis aggressively by selling a near-term option against the asset in the trade - the further-dated long option.

Long Put Diagonal Spread Profit/Loss Chart

Long Call Diagonal Spread Profit/Loss Chart

Diagonal spreads are like vertical spreads in the sense that you want them to move in-the-money (ITM). A long diagonal spread is nothing more than a vertical spread with a longer-term long option. With this in mind, max profit can be more than the width of the diagonal spread, since the short option will expire prior to the long option. 

The long option will hold extrinsic value as the short option expires, which is how we think of the trade - like a vertical spread with a potential extrinsic value boost in the long option.

If a long diagonal spread is showing a loss, that means the spread is moving out-of-the-money (OTM) and both the long and short options are losing value. Since there is a time difference between the long and short option, there are plenty of defensive tactics we can deploy to continue to hedge and reduce the cost of the long option that remains. This may involve rolling the short option out in time closer to the long option’s expiration, rolling the short option closer to the long option vertically in the same expiration, or a combination of both.

Diagonal debit spreads can be placed in a bullish or bearish manner using calls or puts.

• For a bullish diagonal spread, calls would be used since we’d want the stock to rise in price and for the spread to move ITM and become more valuable.
• For a bearish diagonal spread, puts would be used since we’d want the stock to drop in price and for the spread to move ITM and become more valuable.

Let’s break down the differences more clearly below.

Diagonal spreads can be effective earnings trades if you are directionally correct, and they limit losses if you’re directionally wrong as they’re defined risk debit trades.

Before trading a diagonal spread for an earnings announcement, it is important to be comfortable with volatile profit or loss numbers that naturally occur around earnings announcements and big stock price moves.

The idea behind a diagonal spread for an earnings call is to capture the inflated implied volatility (top yellow rectangle) with the sale of a near-term short option in the earnings expiration cycle, while establishing a directional delta (long put or long call) in a longer-term expiration cycle (bottom yellow rectangle) that has a much lower exposure to the earnings call implied volatility crush.

In the image above, you can see that the IV% numbers are very inflated with near-term expirations, as almost all of the extrinsic value in these cycles is attached to the earnings announcement itself. Longer-term cycles will hold onto extrinsic value as they still have plenty of time before they expire, and more implied volatility because of this.

To recap trading diagonal spreads for earnings, the strategy can be more stable on a small stock price move if the long option is placed in a cycle that has a baseline IV% that is similar to other long-term expiration cycles. If the weekly cycle has inflated IV%, the expected move will be inflated relative to the time-adjusted expected move in the back month.

In the example above, the expected move for the October cycle with 50dte is +-39.90, where the September 2nd cycle with 1dte expected move is +-19.41. That is a massive chunk of the 50dte expiration cycle, and that is why the premium in the 1dte cycle is so inflated relative to the October cycle.

Diagonal debit spreads are defined risk directional trades where profit potential depends on the directional movement of the stock price. Since the most we can lose is the debit paid up front, the monetary risk is controlled by the entry price. Let’s dig in deeper below.

The setup of a diagonal spread is very important. If we have a bad setup, we can actually set ourselves up to lose money if the trade moves in our direction too fast. To ensure we have a good setup, we check the extrinsic value of our longer dated ITM option. Once we figure that value, we ensure that the near term option we sell is equal to or greater than that amount. The deeper ITM our long option is, the easier this setup is to obtain. We also ensure that the total debit paid is not more than 75% of the width of the strikes.

We never route diagonal spreads in volatility instruments. Each expiration acts as its own underlying, so our max loss is not defined.

WHEN TO CLOSE

We generally look for 25-50% of max profit when closing diagonal spreads. Profit occurs when the long option moves further ITM and gains value, and/or if implied volatility increases.

WHEN TO MANAGE

We manage diagonal spreads when the stock price moves against our spread. In this case, we look to roll down the short option closer to the breakeven price, so that we can collect more premium and reduce our overall risk.

Diagonal spreads and vertical spreads share a similar characteristic in the sense that they both have a long and short option on different strikes.

A vertical spread’s long and short options share the same expiration, whereas a diagonal spread’s long and short options are in different expirations. 

Long Call Vertical Profit/Loss Chart

Long Put Vertical Spread Profit/Loss Chart

Typically, the long option has more time to expiration than the short option. This results in a more costly trade upfront, but much more time for the trade to work out before the long option expires.

Diagonal spreads and calendar spreads share a similar characteristic in the sense that they both have long and short strikes in different expirations.

A calendar spread’s long and short strikes share the same strike price, which makes it a cheaper trade on entry compared to a diagonal spread.

Call Calendar Spread Profit/Loss Chart

Put Calendar Spread Profit/Loss Chart

A diagonal spread’s long and short strikes are on different strikes, and typically mimic a setup of a traditional vertical debit spread. Calendar spreads are much more about theta decay and IV changes, whereas a diagonal spread has a directional nature to it.