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What is a Diagonal Spread and How does it work

10 Jul 2023

Introduction

With a diagonal spread, you can create a profitable position while reducing your exposure to market fluctuations. But where do you start? Let's take a deep dive into diagonal spreads, what they are, and how to leverage them for your advantage.

What is a diagonal spread?

A diagonal spread is a commonly used trading strategy. It involves purchasing and selling options with varying expiration dates and strike prices. In a diagonal spread, you buy a longer-term option and sell a shorter-term option at a higher strike price.

For example, you might buy a call option that expires in six months with a strike price of $50. You can sell a call option that expires in three months with a strike price of $55 with the idea that the price will increase over time. Then, the longer-term option will increase in value faster than the shorter-term option leading to profits.

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What are the types of diagonal spreads?

There are two types of diagonal spreads:

1. Call diagonal spreads 

A call diagonal spread involves buying a call option with a later expiration date. Then selling a call option with an earlier expiration date at a higher strike price. Call diagonal spreads are bullish strategies, meaning you expect the price of the underlying asset to increase. 

2. Put diagonal spreads

The put diagonal spreads are bearish strategies, meaning you expect the price of the underlying asset to decrease. A put diagonal spread strategy requires purchasing a put option with a later expiration date. Then you sell a put option with an earlier expiration date at a lower strike price. Both types of diagonal spreads can be used to generate income or as a way to hedge against potential losses.

How to choose the right diagonal spread?

Choosing the right diagonal spread depends on your trading strategy and market outlook.

If you're bullish on a particular stock or asset, you might consider a call diagonal spread. If you're bearish on a particular stock or asset, you might consider a put diagonal spread.

Consider the expiration dates and strike prices of the options you're buying and selling. The longer the expiration date, the more time you have for the underlying asset to move in your favour. Longer-term options are more expensive than shorter-term options.

What are the benefits of diagonal spreads?

The main benefits of diagonal spreads can be divided into two parts:

  1. They allow you to create a profitable position while reducing your exposure to market fluctuations. One way to benefit from the time decay of options is to purchase a long-term option and sell a short-term option at a higher strike price simultaneously. This means that the shorter-term option will lose value faster than the longer-term option, resulting in profits.
  2. You receive the premium by selling options, which is essentially your income. If the options expire worthless, you keep the premium as profit. If the options are exercised, you're obligated to buy or sell the underlying asset at the strike price.

The profit potential of a diagonal spread is the difference between the strike prices of the options and the premium paid or received. The loss potential of a diagonal spread is limited to the premium paid.

Expert Tips

Here are some expert tips to help you succeed with diagonal spreads:

1. Choose the right options based on your market outlook and trading strategy.

2. Monitor the position closely and adjust as necessary.

3. Use stop-loss orders to limit potential losses.

4. Be patient and don't panic if the position goes against you.

5. Understand the potential risks and rewards before entering the trade

To conclude

To avoid risks while using diagonal spreads, you must avoid over-leveraging and being too aggressive. Monitor the position and use stop-loss orders to limit potential losses. It's important to remember that diagonal spreads are advanced trading strategies. They must be used only by experienced traders who understand the potential risks and rewards.

 

Related Articles: How does a spread contract help in currency trading | Box Spread Trading Strategy | Synthetic Options Spread A Guide for Traders

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